December 6, 2014

How to do Financial Analysis of a Company



“Selecting Top Stocks to Buy” is a series of articles that focuses on the process of selection of stocks for investment. Until now, we have learned about:



Current article in this series would focus on the financial analysis of a company. In “Part 4: framework for detailed analysis” we learned that the detailed analysis of any company consists of Financial, Business & Industry, Management and Valuation analysis. 

Financial analysis is being discussed first as it forms the basic back bone and first filter for selecting stocks for further analysis. Only the stocks that satisfy the criteria of good financial performance should be worthy of spending further time.

If this is the first part of this series, which you are reading then I would request you to essentially read “Part 4: framework of detailed analysis of a company” and “Part 5: Understanding the annual report of a company” before you read the current article. 

Reading previous parts is essential as each new article in this series builds upon the concepts already discussed in earlier parts. Many of the concepts that are going to be elaborated in current article have already been introduced in Part 4 and Part 5.

As mentioned in Part 4
“The aim of financial analysis is to analyze the amount of income it earns in sales, amount of profits it is able to retain for shareholders after factoring in all expenses & taxes and the growth in sales & profits over past. Financial analysis also focuses on the sources of funds, which a company has used for creating its assets. It also involves the analysis of the amount of cash it generates from its operations and utilization of this cash, whether for investments or debt repayment etc. The aim is to find companies, which have a healthy financial position that can offer potential for future growth.”
Financial analysis consists of studying three paramount sections of the annual report and analyzing them in detail. These three sections are Balance Sheet (B/S), Profit & Loss statement (P&L) and Cash Flow statement (CF).

Before you begin to feel that financial analysis might contain a lot of mathematics and difficult calculations, I want to tell you that the entire financial analysis consists of study of only two things: Ratios and Growth rates. As we delve deeper into financial analysis, we would see that it entails reading the annual reports, noting down some relevant numbers from it and study various ratios of these numbers and their growth rates over the years.

To further simplify the things, readers would be happy to note that, now a day an investor does not need to see the financial numbers in annual report of the company and punch in the numbers in a data analysis software like Microsoft Excel (excel). The investor can use free resources on the internet, which can provide readymade data files containing financial details of companies which the investor can use in excel to perform a good analysis. One such free resource available to investors in Indian equity markets is www.screener.in 

At www.screener.in, the webpage for every company has a link stating- “Export to Excel”.   

How to do financial analysis of a company balance sheet profit and loss cash flow statement


You can download the excel file of financial data of the company by clicking this link.

Once ready with the data, doing financial analysis is a breeze. However, if any investor is not verse with using data analysis software like excel, he can use the calculators to find out the ratios and growth rates. The result by both means would be the same. However, excel would make the analysis easier to perform.


ANALYSIS OF PROFIT AND LOSS STATEMENT (P&L)


Sales Growth:


First parameter to check is the growth of sales that a company has achieved in the past. Companies that have a product or service, which is high in demand usually show high growth of sales in past. 

Vinati Organics Ltd (VOL) is a world market leader in two of its products. Its products have witnessed good demand and therefore its sales have increased by leaps & bounds in past:

Year
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Sales (INR Cr.)
49
58
84
150
194
237
322
447
553
696

Thus we can see that sales of VOL have grown from INR 49 cr (0.49 billion) in 2005 to INR 696 cr (6.96 billion), which means a compounded average growth rate (CAGR) of 34% over last 10 years. An investor should prefer companies that have grown at least at a rate of 15% or more in past. One should note that very high growth rates of 50% or more are unsustainable in long run.

Profitability:



Profitability can be measured by two prominent measures operating profit margin (OPM) and net profit margin (NPM). 

OPM measures the portion of sales income that is remaining after deducting costs of producing these sales e.g. raw material costs, employee costs, sales & marketing costs, power & fuel costs etc. Operating profit does not factor in expenses like depreciation of fixed assets, interest and tax expenses. 

NPM reflects the net profit that remains after a company has paid its interest, tax and factored in depreciation. Net profit is final remnant after meeting all expenses and is available with the company for reinvesting or distributing to shareholders as dividend.

An investor’s aim is to find companies with good profitability, which they have been able to sustain in the past. Companies with high profit margins are able to face tough times comfortably and still make money for their shareholders. 

Let us analyse the profitability of VOL. All figures are in INR Cr. (10 million). Some calculations might show some mismatch because of rounding off.

Year
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Sales (A)
49
58
84
150
194
237
322
447
553
696
Operating Profit (B)
7
6
10
29
37
58
70
95
120
153
OPM% (B/A)
15%
11%
12%
20%
19%
24%
22%
21%
22%
22%
Other Income(C)
0
0
0
0
0
1
2
3
4
9
EBIDT* (D=B+C)
7
7
10
30
37
58
71
98
124
162
Depreciation (E)
2
2
3
3
3
5
6
7
10
15
Interest (F)
1
1
2
3
3
4
5
9
12
18
Profit before tax (G=D-E-F)
5
3
6
23
31
49
60
82
103
129
Tax (H)
1
1
2
8
7
12
11
27
34
42
Net profit
(I=G-H)
3
2
4
15
25
40
52
55
69
86
NPM% (I/A)
7%
3%
4%
10%
13%
17%
16%
12%
12%
12%
*EBIDT: Earnings before interest depreciation and taxes

We can see that the OPM for VOL witnessed an increase during period 2005 to 2010 from 15% to 24% indicating improving efficiency of operations. Thereafter, company has been sustaining OPM levels of about 22% since last 5 years, which is a very good sign about operating efficiency of VOL. NPM has also seen similar trend by initially increasing from 7% to 17% and then sustaining at about 12% levels.

Tax:


A company with good accounting and corporate governance standards would want to pay all legitimate taxes to the government. In India corporate tax rate is 30% for Indian companies and 40% for foreign companies. 

There are many tax incentive schemes for different companies/industries/states etc, that provide many tax saving avenues that companies use to lower tax expense. Nevertheless, abnormally low tax payouts should raise red flags and must be analysed. 

Let us see tax payout histories of VOL. Figures are in INR Cr. (10 million). Some calculations might show some mismatch because of rounding off.

Year
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Profit before tax (A)
5
3
6
23
31
49
60
82
103
129
Tax (B)
1
1
2
8
7
12
11
27
34
42
Tax% (B/A)
31%
39%
35%
34%
22%
24%
18%
33%
33%
33%

We can see that the company has been paying tax mostly at the rate of corporate tax, which is a healthy sign. Tax payouts also give a glimpse about the management quality and integrity. Hence, we would revisit tax payouts while discussing management analysis in future parts of this series.

Interest coverage:


Interest coverage gives an indication whether the operating profits generated by the company are sufficient to pay interest to the lenders for the funds it has borrowed from them. It can be measured by ratio of operating profit to interest expense called Interest Coverage Ratio:



Interest Coverage Ratio = Operating Profit / Interest Expense


An investor should look out for companies that have interest coverage of at least 3. It implies that they make operating profit of at least INR 3 whereas their interest expense is INR 1. 

Higher interest ratio provides a cushion during bad economic times and the company would not find it difficult to service its debt even during bad times. 

Let us see the interest coverage of VOL. Figures are in INR Cr. (10 million). Some calculations might show some mismatch because of rounding off.

Year
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Operating Profit (A)
7
6
10
29
37
58
70
95
120
153
Interest (B)
1
1
2
3
3
4
5
9
12
18
Interest coverage (A/B)
7
6
5
9
11
14
16
10
10
9

We can see that VOL has been maintaining an interest coverage ratio of about 10-15 over the years. It means that VOL would be able to service its debt even in bad times without much issue.

One important thing to note here is that every investor defines these ratios and growth rates as per her own preference. There is no single defined way of analyzing financial statements. 

Warren buffet prefers owner’s earning over net profit. Many investors like to include non-operating income while calculating interest coverage. Nevertheless, I prefer to use only operating income and avoid non-operating income while calculating interest coverage. 

Therefore, the more investors you interact and the more authors you read, you would find that everyone has her own way of analyzing financial statements. You should not be bogged down by different formulas used by different investors. You should try to analyze and find out the parameters/ratios that differentiate the companies, which you feel comfortable investing in.


ANALYSIS OF BALANCE SHEET (B/S)


Debt to Equity ratio (D/E, Leverage):


D/E ratio measures the composition of the funds that a company has utilized to buy its assets. Company uses its assets to produce goods & services that bring the sales revenue to the company. D/E shows how much of the total funds employed by the company are its own (shareholder’s funds) and how much are borrowed from other lenders. D/E of 1 means that 50% of funds are brought by shareholders and rest 50% are borrowed from lenders.

I prefer companies, which have very low debt. During bad times when the company might not be able to make good profits, lender will ask for their money and the company might have to sell its assets in distress to pay back the lenders. If the company is not able to find buyers willing to pay sufficient money, it can become bankrupt. Therefore, investors should prefer companies with low debt to equity ratio.

Let us see the debt to equity ratio of VOL over time. Figures are in INR Cr. (10 million). Some calculations might show some mismatch because of rounding off.

Year
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Equity Share Capital (1)
7
7
7
10
10
10
10
10
10
10
Reserves (2)
20
21
23
33
55
89
134
177
231
300
Total shareholder's funds (E=1+2)
26
27
30
43
65
99
144
187
241
310
Secured Loans (3)
16
19
21
28
45
57
70
118
163
88
Unsecured Loans (4)
0
3
5
6
6
6
7
36
38
34
Total debt (D=3+4)
16
23
26
34
51
63
77
153
201
122
D/E
0.6
0.8
0.9
0.8
0.8
0.6
0.5
0.8
0.8
0.4

We can see that VOL has been maintaining D/E less than 1 consistently. D/E increased in 2012-13 when the company was increasing its capacities and raised debt to fund its expansion plans. Once the expanded capacity became functional, it used the extra profits it could make to pay off its debt (from Rs. 201 cr. to Rs. 122 cr.) and brought down its D/E in 2014 to 0.4.

Some investors like to use only secured or long term debt for calculating D/E ratio. However, I prefer taking total debt for calculating D/E ratio.

Current Ratio (CR):


CR is calculated as a ratio of current assets of a company to its current liabilities.  



Current Ratio = Current Assets / Current Liabilities


Current assets (CA) are the assets that are consumed within next one year. They include inventory that gets consumed and gets sold as finished product within a year, cash & similar investments kept by the company to meet day to day requirements and money due from customers (account receivables or debtors) and  loans given to different parties that are expected to be received back within a year. 

Current liabilities (CL) include payables within next one year and the short-term provisions. 

CR of >1 means that the company has CA which exceed CL and that the company would be able to pay off its near term liabilities by the money it would receive from current assets.

Let us see the current ratio (CR) of VOL over time. Figures are in INR Cr. (10 million). Some calculations might show some mismatch because of rounding off.

Year
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Inventories (A)
9
8
8
12
12
19
35
43
55
47
Receivables (B)
8
13
20
22
28
36
52
86
113
115
Cash (C )
0
1
0
0
0
0
0
32
34
45
Current Assets (CA=A+B+C)
17
22
28
34
40
55
87
161
202
207
Current Liabilities(D)
12
12
15
18
18
19
29
50
86
99
Provisions (E )
1
1
1
3
4
4
8
14
19
21
Total CL (CL=D+E)
12
13
17
21
22
23
38
64
105
120
CR (CA/CL)
1.4
1.7
1.7
1.6
1.9
2.4
2.3
2.5
1.9
1.7

We can see that VOL has been consistently maintaining CAs in excess of CLs, which is a very healthy sign. Investors should look for companies that have CR of at least 1.25 or more.


ANALYSIS OF CASH FLOW STATEMENT (CF)


This section provides details of the cash that a company has generated in last financial year from operation (cash flow from operations or CFO). This section also includes details of cash used in making investments or received from selling investments (cash-flow from investing activities or CFI) and cash raised from financial institutions as borrowings or repaid to them during the last year (cash-flow from financing activities or CFF).

An investor should focus on companies, which generate good amount of cash flow from operations that can take care of their requirements of investment (CFI) and repayment of debt (CFF). If an investor can find a company that generates so much cash that after taking care of CFI and CFF, it still has surplus left, she would have hit a jackpot.

Let us see the cash flow statement of VOL over time. Figures are in INR Cr. (10 million). Some calculations might show some mismatch because of rounding off. Positive values mean cash inflow and negative values mean cash outflow.

Year
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
CFO (A)
4
2
2
12
27
29
31
20
92
134
CFI (B)
-8
-7
-3
-17
-40
-35
-39
-61
-113
-9
CFF (C )
1
5
1
5
13
6
7
72
22
-113
Net Cash Flow (A+B+C)
-2
1
-1
0
1
0
0
30
2
12
Cash at the end of year
1
1
1
1
2
2
2
32
34
45

We can see that VOL has been generating good amount of cash from operations year on year. CFO has increased during 2005-14 from INR 4 cr. (0.04 billion) to INR 134 cr. (1.34 billion). We can observe that during 2005-13, VOL was funding its expansion plans (negative CFI) by a mix of operating cash (CFO) and debt (CFF). 

In 2014, the company did not undertake any major expansion. The expansions done in past year is bringing in increased cash each year for VOL. In 2014, the company used this cash to pay off its debt (CFI is -113 cr.) and reduced its debt from INR 201 cr. to INR 122 cr. (see table in D/E section above).


PARAMETERS USING MIX OF B/S, P&L AND CF


Until now, we have used ratios and growth rates that utilized figures from either B/S or P&L or CF alone. We have not used the ratios/parameters that utilize figures across these three financial statements. 

Comparative analysis of B/S, P&L and CF is necessary, as it will provide a sanctity check on the numbers reported by any company. It will also provide further insights into the financial position and operating efficiency of the company. Some of the parameters that indicate operating efficiency of a company use a mix of B/S and P&L like: Inventory turnover ratio, receivables turnover, payables turnover etc.

Read: How to Analyse Operating Efficiency of Companies

These parameters are the next level of analysis, which an investor should do when she is well verse with the parameters discussed above. However, one analysis that compares P&L with the CF is mandatory for each investor to perform on every company she is studying. It compares the cumulative net profit (profit after tax, PAT) of last few years with the cumulative CFO of the same period.

Cumulative PAT vs. cumulative CFO:


A company that sells any product today might not receive its payment immediately. However, it is legitimately eligible to receive it. Therefore, accounting standards allow it to report this sale and its profit in the P&L. However, the money received from buyer will be reflected in CFO only when the money is actually received from the buyer. 

Therefore, if we compare PAT and CFO for any one year, they would differ from each other. However, over a long time, cumulative PAT and CFO should be similar.

If cumulative PAT is similar to CFO, it means that the company is able to collect its profits in actual cash from its buyers. If CFO is abysmally lower than PAT, it would mean that either the company though legitimately eligible to receive money from buyer, is not able to collect it or the profits are fictitious. In either case, the investor should avoid such a company.

Let us compare cumulative PAT and CFO of VOL over time. Figures are in INR Cr. (10 million). Some calculations might show some mismatch because of rounding off.

Year
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Total
PAT
3
2
4
15
25
40
52
55
69
86
351
CFO
4
2
2
12
27
29
31
20
92
134
353

We can see that VOL registered profits of INR 351 cr. (3.51 billion) during 2015-2014 and collected INR 353 cr. (3.53 billion) net cash flow from operations. This is a very healthy sign for any company.


CONCLUSION


In the current article in the series “Selecting Top Stocks to Buy”, we learnt about financial analysis of a company in details. The parameters discussed above are essential ones and should suffice for basic due diligence by any retail investor. As we would agree that there is never an end to the analysis and analysts do spend years analyzing companies. There are hundreds of more ratios, which can be used to gain further insights into financial position of any company

However, I believe that if a retail investor can analyse the eight parameters discussed above and importantly understand the trend of these parameter over the life of company, then she would easily be able to select financially sound stocks out of thousands of options available to her. She would also be able to avoid financially bad companies and spare a lot of her time that might have gone into studying such bad companies further. I would summarize the eight financial parameters here:
  1. Sales growth: Look for high and sustainable growth >15% per year. Growth rate of >50% are unsustainable. 
  2. Profitability: Look for high and sustainable OPM and NPM. I prefer companies with NPM of >8%.
  3. Tax: Tax rate should be near general corporate tax rate unless some specific tax incentive are applicable to the company.
  4. Interest coverage: Look for companies with interest coverage ratio of >3. 
  5. Debt to Equity ratio: Look for companies with low/nil debt. Preferably D/E <0.5
  6. Current ratio: Look for companies with CR >1.25 
  7. Cash flow: Positive CFO is necessary. It's great if CFO meets the outflow for CFI and CFF. 
  8. Cumulative PAT vs CFO: Look for companies where cumulative PAT and CFO are similar for last 10 years. 
In the past there have been many instances where managements/companies have tried to use shortcuts to show good financial performance in reported numbers when the actual business on the ground was not doing well. Such instances have been common throughout the world whether it be Enron in USA or Satyam in India. 

It is important that every investor learns about the tricks being used by such managements and while doing financial analysis takes care to find out whether the performance being shown is genuine or artificially made up. 

The following article would help a reader find out common shortcuts used by companies to dress up their financial statement:

7 Signs to tell whether a Company is cooking its Books: "Financial Shenanigans"

In future articles on the series “Top Stocks to Buy”, I would discuss remaining sections of detailed analysis of a company: Management, Business & Industry and Valuation analysis. 

I would like to have your feedback on this series of articles. It would be very helpful if you can tell the readers about the parameters you use for financial analysis of stock. You may write about your experiences and learning in stocks markets in the comments below. 

P.S. I have used the financial data of Vinati Organics Ltd, provided by www.screener.in and www.moneycontrol.com for this post.