How Business Drivers Travel Down to Earnings Per Share

A movement at the top of the profit ladder arrives at the bottom magnified. Every rung below it takes out a cost that grew more slowly. In the published year Sarvani Coatings Limited's revenue rose 13.92 per cent and its profit after tax rose 41.12 per cent. The widening is arithmetic. Reading it as achievement is the error, and the same arithmetic magnifies a fall.

Underneath that answer sits the shape of the ladder itself, settled in the accounting layer: revenue at the top, then a chain of subtractions, each one leaving a smaller remainder than the one above it. Earlier work has already built the revenue line from its drivers, built the cost lines, assembled a model and ranked which driver is worth most. A different question follows. Once a movement enters the top of that ladder, what happens to it on the way down, and how much of what comes out at the bottom was ever anybody's doing?

Why does taking a cost away make a movement bigger?

A tiffin service carries this better than a listed company does. The arithmetic is identical and the numbers are small enough to hold in the head. A plate sells for Rs 100/-. Groceries for that plate cost Rs 60/-. Rent and one helper cost Rs 30/-. The cook keeps Rs 10/-. Now the plate goes to Rs 105/- with nothing else changed: no extra grocery cost, no extra rent. Takings are up 5.00 per cent. The amount kept has gone from Rs 10/- to Rs 15/-, up 50.00 per cent. Ten times the movement, and the cook did nothing except charge five rupees more.

Nothing in that example is skill, and nothing in it is leverage in the borrowing sense; it is a subtraction sitting between a big number and a small one. The extra five rupees is the same five rupees at every level. Those five rupees are 5 per cent of a hundred and 50 per cent of ten. The base under them shrank while the change itself did not. Every rung of a profit ladder does exactly this. Revenue is the widest base on the ladder. Each line below it is what remains after something has been taken out, so each base is narrower than the last, and the same absolute rupee lands on it as a larger percentage.

The whole mechanism shows itself without moving anything at all. One identical Rs 100 crore, read against each rung of Sarvani Coatings' published year three, without asking where it came from or whether it was earned. Against revenue of Rs 2,415 crore it is 4.14 per cent. Against gross profit of Rs 1,111 crore it is 9.00 per cent. Against earnings before interest, tax, depreciation and amortisation ( EBITDAThe rung reached after operating costs have been taken out but before depreciation, interest and tax. Settled in the accounting layer and used here as a level, not explained again. ) of Rs 446 crore it is 22.42 per cent. Against earnings before interest and tax (EBIT) of Rs 354 crore it is 28.25 per cent, and against profit after tax of Rs 278 crore it is 35.97 per cent. One rupee amount, five readings, and the highest is nearly nine times the lowest.

What did the widening actually look like, rung by rung?

Now compute it rather than reading it. Sarvani Coatings' year three against its year two, every rate worked from the two published ladders instead of taken from anybody's summary. Revenue grew 13.92 per cent. Gross profit grew 19.08 per cent. EBITDA grew 31.18 per cent. EBIT grew 38.28 per cent. Profit before tax grew 41.06 per cent, and profit after tax grew 41.12 per cent. Six rates, and each one is larger than the one above it. Nothing narrows anywhere on the way down.

A fan like that looks like a story about a company getting better and better further down the ladder. Careless writing starts there. The fan is not a story yet. Six numbers sit on the ladder, and the useful move is to stop reading them and start subtracting them from each other. Subtract the bottom rate from the top one: 41.12 less 13.92 is 27.20 percentage pointsThe unit for the gap between two percentages. The difference between 13.92 per cent and 41.12 per cent is 27.20 percentage points. A 27.20 per cent difference is not the same thing.. Every one of those points was created by one specific subtraction on the ladder, and each subtraction can be isolated.

The five steps between the six rates must sum exactly to the gap between the top rate and the bottom one, and a split that does not sum has quietly lost a step somewhere. Here they do sum. Revenue to gross profit contributes plus 5.16 points. Gross profit to EBITDA contributes plus 12.10. EBITDA to EBIT contributes plus 7.10. EBIT to profit before tax contributes plus 2.78, and the last rung, tax, contributes plus 0.05. Add them: 5.16 plus 12.10 plus 7.10 plus 2.78 plus 0.05 is 27.20, and 41.12 less 13.92 is also 27.20. The split closes, so nothing has been left out and nothing has been double counted.

How much of it came from the gross margin?

Less than the volume of writing about it would suggest. The first step, revenue down to gross profit, is worth 5.16 points of the 27.20. The step exists because the gross marginHow much of each rupee of sales survives the materials bill. Sarvani Coatings kept 44.0 paise in the rupee in year two and 46.0 paise in year three. improved by two points on the year, 44.0 per cent becoming 46.0, and two points on a base of that size buys 5.16 points of extra growth further down. The gain is real. The step is also the smallest of the three big ones, and it is the one that will get the whole paragraph in a results commentary.

The step's reach needs stating precisely. The drivers underneath it were built earlier. Over the one year from year two to year three, volume rose 6.0 per cent while realisationRevenue divided by units sold, the average price actually collected per unit. Built from drivers earlier in this sequence. rose about 7.5 per cent and the materials cost per unit of output rose about 3.6 per cent. The input cost did not fall. The gain came entirely from realisation outrunning input cost, and the published statements cannot say whether the credit belongs to a pricing environment the whole field enjoyed, to what this company itself decided to charge, or to a shift in mix towards industrial. No published statement closes that question. The step is 5.16 points, the smaller half of the story and routinely reported as the whole of it.

How much came from the cost lines, and did those costs fall?

The largest single contributor is the second step, gross profit down to EBITDA, at 12.10 points. The second step is more than twice the gross margin step of 5.16 points, and on its own it accounts for 44.48 per cent of the whole 27.20 point widening. Nearly half the widening sits in that one step. Most write ups of a year like this do not mention it at all.

The reason it goes unmentioned is that nothing visible happened there. The operating costsEmployee cost and other expenses taken together. Sarvani Coatings reports advertising and sales promotion and freight and distribution inside other expenses. did not fall; they rose, and the amplification happened anyway. Employee cost moved up to Rs 205 crore from Rs 186 crore and other expenses to Rs 460 crore from Rs 407 crore. Together that is Rs 593 crore becoming Rs 665 crore, a rise of 12.14 per cent. Nobody cut anything. Nobody froze hiring. The step is worth 12.10 points because gross profit grew 19.08 per cent while those costs grew 12.14 per cent, and because what is left after the subtraction started from a base of only Rs 340 crore.

Put in rupees, the mechanism stops being mysterious. Gross profit rose by Rs 178 crore. The operating costs rose by Rs 72 crore. The difference, Rs 106 crore, is exactly what landed on EBITDA, taking it from Rs 340 crore to Rs 446 crore. A Rs 106 crore addition to a Rs 340 crore base is 31.18 per cent. The same Rs 106 crore against revenue of Rs 2,120 crore would have been 5.00 per cent. The rupees never changed; only the base they are divided by did.

What did depreciation, the finance cost and tax contribute?

The third step, EBITDA down to EBIT, is worth 7.10 points and comes entirely from depreciation and amortisationThe yearly write down of assets already bought and already in use. The charge sits in the profit ladder and moves no cash in the year it appears. growing more slowly than EBITDA did. The charge went from Rs 84 crore to Rs 92 crore, a rise of 9.52 per cent, against EBITDA growing 31.18 per cent. A charge that grows at a third of the rate of the line above it widens the gap by definition.

There is a detail behind that number worth knowing about, though it is not settled here. Sarvani Coatings carries Rs 118 crore of capital work in progressMoney already spent on an asset that is not yet commissioned, so it sits on the balance sheet and is not yet being written down through the profit ladder., a coatings line not yet commissioned. Spending that has not yet reached the depreciation charge is doing part of the work in this step, and it will reach the charge later. How an asset not yet commissioned is treated, and when it starts being written down, is an accounting question covered separately rather than here.

The fourth step, EBIT down to profit before tax, is worth 2.78 points, and it is two movements in one. The finance cost fell 12.5 per cent, from Rs 24 crore to Rs 21 crore. Other income rose 22.58 per cent, from Rs 31 crore to Rs 38 crore. Together the net item below EBIT went from plus Rs 7 crore to plus Rs 17 crore. Had that net item simply been held at Rs 7 crore, profit before tax would have grown 37.26 per cent, 1.02 points below EBIT growth rather than above it. A constant positive addition dilutes a growth rate. The Rs 10 crore of movement then adds 3.80 points on top. Minus 1.02 plus 3.80 is the 2.78 the step is worth.

The last step, tax, contributes 0.05 points, and it is the line that models spend more effort on than any other below EBIT. The effective tax rateThe tax charge stated as a percentage of profit before tax. Sarvani Coatings paid Rs 66 crore on Rs 263 crore in year two and Rs 93 crore on Rs 371 crore in year three. moved from 25.10 per cent to 25.07 per cent. Three hundredths of a point of rate, worth five hundredths of a point of growth, on the best disclosed and most modelled line on the whole ladder. The operating cost step, by contrast, is 12.10 points, a residual nobody set out to produce.

What happens when the same arithmetic runs backwards?

The reverse direction is the part that gets left out, and leaving it out turns arithmetic into a compliment. A subtraction has no opinion about direction. If the gap between a big base and a small one magnifies a rise, it magnifies a fall by the same mechanism, and it does so without anybody deciding anything.

Work it on the same ladder. Hold the gross margin at 46.0 per cent, hold the operating costs at their year three rupees of Rs 665 crore, and put revenue down 10 per cent to Rs 2,173.5 crore. Gross profit becomes Rs 999.8 crore. Take the Rs 665 crore out and EBITDA is Rs 334.8 crore, down 24.93 per cent from Rs 446 crore. Carry it down: depreciation held at Rs 92 crore leaves EBIT at Rs 242.8 crore, the finance cost and other income held leave profit before tax at Rs 259.8 crore, and the year three effective rate leaves profit after tax at Rs 194.6 crore. Earnings per share go from Rs 11.58/- to about Rs 8.11/-, a fall of 29.97 per cent.

A 10 per cent fall in revenue becomes a 30 per cent fall in earnings per share, and nobody has to do anything differently for it to happen. Two strong assumptions carry that illustration. A real business would not hold its operating costs at last year's rupees while its revenue fell a tenth. The ladder also does not widen at literally every rung on the way down here. Holding the finance cost and other income in rupees leaves that net Rs 17 crore cushioning profit before tax: EBIT falls 31.41 per cent and profit before tax falls 29.97 per cent. The assumption behind the illustration is showing through, not a discovery about the company.

Push the control right up to the setting where the operating costs grow exactly as fast as revenue did. The setting is Rs 675.5 crore, up 13.92 per cent from Rs 593 crore, and it is worth reaching by hand: the whole argument sits in one place there. EBITDA there is Rs 435.5 crore, still growing 28.1 per cent against revenue at 13.92 per cent. The base under the profit line is a fifth of the size of the base under the sales line. Even when costs grow exactly as fast as sales, profit still grows at twice the rate of sales. The fan does not close anywhere on that control, and that refusal is the reading.

Both ends of the control say the same thing. Freeze the operating costs at last year's Rs 593 crore, a feat no real business manages, and EBITDA grows 52.35 per cent. Push them the other way to Rs 713 crore, a rise of over a fifth, and EBITDA still grows 17.06 per cent against revenue at 13.92 per cent. Between those two extremes the profit line never once grows more slowly than the sales line. Amplification of about 2.95 times is not a thing this management team achieved in one year; it is a property of a ladder whose bottom rung is roughly a ninth of the size of its top one.

How does a lender, an analyst or a household use this same shape?

An analyst uses the decomposition in one direction only: to stop a sentence being written. A note that begins with profit growing three times as fast as revenue is not yet a finding. The claim is split, checked that it sums, and each step is labelled with the cost line that produced it. The 12.10 point step is where the money was, and the note describes it as a cost base growing more slowly than a gross profit base, a fact about proportions.

A lender reads the same ladder from the other end and only cares about the reversal. Covenant headroom is not set by how far profit rises in a good year. Headroom is set by how far profit falls in a bad one, and this ladder tells the lender that a tenth off revenue takes roughly a third off earnings, before anybody has done anything wrong. A lender therefore asks about the fixed portion of the cost base rather than about last year's growth rate.

And the household version is the one everybody has already lived. A household running on one salary of Rs 80,000/- a month, with an equated monthly instalment of Rs 30,000/- and fixed running costs of Rs 35,000/-, has Rs 15,000/- left at the end of the month. Take a 10 per cent pay cut, to Rs 72,000/-, and the instalment does not move and the rent does not move. The money left goes to Rs 7,000/-, a fall of 53.3 per cent. The salary moved a tenth and the money that actually decides the month moved more than half, for exactly the reason Sarvani Coatings' profit line moves three times as far as its revenue line.

What does the amplification establish, and what does it not?

The amplification establishes the shape of the ladder, precisely and usefully. The shape shows a cost base large enough and slow enough that small movements at the top arrive at the bottom about three times bigger. The shape also sets out what to expect in a bad year without any guesswork. Knowledge of that kind is genuine and checkable, and the decomposition is worth doing for it.

The amplification establishes nothing whatever about whether the movement at the top was earned. The 27.20 points are a consequence of the ladder's shape acting on a driver that moved. Where that driver's movement came from is a separate question, and on this record it is a question that stays open: over the year, realisation rose about 7.5 per cent while materials cost per unit of output rose about 3.6 per cent, and the published statements do not separate a pricing environment the whole field enjoyed from what this company itself decided to charge from a shift in mix. A larger number at the bottom of the ladder does not settle any of the three. The bottom number is the same evidence, multiplied.