Analyzing operating performance of any company is a critical step before taking any investment related decision about any company. It tells an investor whether any company is improving its activities year on year and should be a potential investment candidate or on the contrary, its performance is deteriorating with time and any investment in its stock should be avoided.
I thank one of the readers of the website, Satya Prakash, for asking certain queries, which led to the idea of writing this article containing the framework of analysis I use for assessing operating performance of companies.
Past operating performance becomes critical, as it is the outcome of all the business strength (Moat) and intellectual power (Management) any company has. If a company has been touted as the one with huge moat, however, does not deliver in terms of operating performance, then an investor should be quite wary of relying on such claims. On the contrary, some hidden gems in the markets, which never get media attention, have strong business advantages and managements and keep on showing improved operating performance year on year. If an investor is able to analyse and judge the operating performance of a company over years, then she can easily find out strong investment worthy stocks that can generate significant wealth for her over long periods.
Past financial performance data is presented by the companies in their annual reports. Until now, it used to be very cumbersome for an investor to collect such data, as it involved punching the data from annual reports into a spreadsheet and analyzing it under different ratio/parameters.
However, currently, investors have different freely available tools, which provide the read to consume data in spreadsheet format about different companies. An investor can download such data from these online sources, analyse it using certain parameters, and come to know whether any company has been showing improved/stagnating/deteriorating operating performance over the years.
In Indian stock markets, such data for past 10 years is provided by portals like Screener.in Morningstar.in etc. Other foreign markets would have similar portals where an investor can get the financial performance data of companies and analyse it.
A simple framework of analyzing operating performance takes it origination from the basic premises of the objective of existence of any company, which is to grow the wealth of its shareholders. This premise can be broken down into simpler steps, which a company needs to follow over its lifetime:
- Companies need to grow,
- Maintain or improve profitability,
- Operate efficiently,
- Convert profits into free cash and
- Use this free cash to fund future growth.
Let us now understand the tools used to analyse the performance of any company over these parameters. Ideally, an investor should analyse the data for past 10 years, which is easily available on above-mentioned portals.
A) Companies Need to Grow (Sales Growth):
It is expected that every company, which would generate good returns for its shareholders, would grow its business and produce increased sales year on year.
It can be measured through the compounded annual sales growth (CAGR) of sales over the years. The investor should observe that such sales growth is consistent year on year, rather than abnormal spike in one or two years, which hide the otherwise poor performance of multiple years.
B) Maintain or Improve Profitability:
Profitability is measured by operating profit margins (OPM) and net profit margins (NPM) of any company
Operating Profit is the residual profit after deducting the cost of raw material, employee costs, sales & general expenses etc. from the sales revenue of any year. It shows the profitability of any company before the charges for capital structure (interest expense for debt raised) and capital-intensity (depreciation) of any business or taxes are deducted from sales revenue. OPM measures the profitability purely from core operations of any company without factoring in the non-operating income like interest income or dividend income.
Net Profit is the final amount remaining in the hands of equity shareholders after all possible expenses like interest, depreciation, taxes etc. are deducted from total income (including operating sales revenue and non-operating income). This amount is available to the company for either distributing to shareholders like dividends or investing in company’s operations as shareholder’s incremental contribution in the business.
Analysis of both OPM and NPM are important while analyzing operating performance of any company. Companies should show stable or improving profitability year on year. If profitability is not stable, it fluctuates wildly year on year or is declining consistently, then an investor must delve deeper into understanding the business dynamics of the company. If she is not able to find any satisfactory answer to such undesirable patterns in profitability, then she should avoid this company and look for other investing opportunities.
You should read the analysis of Honda SIEL Power Products Limited, which presents a case of increasing growth at the cost of profitability:
C) Operate Efficiently:
There are many tools, which an investor can use to measure operating efficiency. However, I believe that the following three tools would provide any investor with simple easy to apply parameter, which would help her get the right conclusion in almost all the cases:
1) Inventory Turnover Ratio:
Inventory turnover ratio (ITR) measures the efficiency with which a company uses its inventory (raw material, work in progress and finished goods) to convert it into final sales. It is measured by the formula:
Inventory turnover ratio:__________________________________________________
Average inventory at start and end of the year
Many investors use cost of goods sold (COGS) instead of sales in the numerator for calculating ITR. Financial analysis provides the investor the flexibility to customize the ratio as per her preference. Therefore, an investor may use either sales or COGS for ITR analysis, however, she should maintain consistency while calculating & interpreting the ratio.
Higher ratio indicates that a company is able to rotate its inventory faster and its capital is not stuck in inventory.
Higher ratio indicates that a company is able to rotate its inventory faster and its capital is not stuck in inventory.
Ideally, Inventory turnover ratio should be stable or increase with improving performance. Declining Inventory turnover ratio should raise the flags and an investor should delve deeper to understand its cause. If the investor is not satisfied with the outcome then she should avoid investment in such company and look for other opportunities.
The above-mentioned case of Honda SIEL Power Products Limited also represents a case of declining inventory turnover.
2) Days of Receivables Outstanding:
Days of receivables outstanding or Receivables Days broadly reflects the average number of days in which customers of any company pay their dues to the company. Receivables Days are calculated as:
Average trade/account receivables (debtors) at start and end of the year * 365
Ideally, the Receivables Days should be stable or declining. If it were increasing, then it would amount that the company is not able to realize its dues from customers in time. This would amount to company using more of bank funding (working capital funding) to meet its day-to-day cash requirements. This would lead to higher interest expense and lower profitability.
The above-mentioned case of Honda SIEL Power Products Limited also represents a case of increasing Receivables Days.
3) Asset Turnover Ratio:
Asset turnover ratio represents the efficiency with which a company utilizes its assets to produces goods for sales. Different kinds of asset turnover ratios are in vogue for assessing the efficiency of capital deployment by a company.
Most common of these ratios are Total Asset Turnover Ratio and Fixed Asset Turnover Ratio. I prefer using Fixed Asset Turnover Ratio as it indicates the usage pattern of operative productive assets like plants and machinery and excludes assets held in form of investments in third parties, cash etc.
Fixed Asset Turnover Ratio is calculated as:
Fixed Assets Turnover Ratio: _________________________________________
Net fixed assets at the end of the year
Many investors use the average of net fixed assets at the start and end of the year for arriving at Fixed Assets Turnover Ratio, which is also right. An investor should do fine if she uses any of these formulas and uses it consistently to compare results over the years.
Financial analysis allows sufficient leeway to investors to experiment with different ratios with tweaking the existing ratios or creating altogether new ones, if an investor believes that it might give a new insight while analyzing a company.
Fixed Assets Turnover Ratio indicates how efficiency a company is using its assets. A Fixed Assets Turnover Ratio of two indicates that every incremental investment of INR 1 in its plants and machinery would increase its sales by INR 2. A higher Fixed Assets Turnover Ratio is always preferable and indicates good use of shareholders’ funds.
Ideally, Fixed Assets Turnover Ratio should be stable or increase with improving performance. Declining Fixed Assets Turnover Ratio should raise the flags and an investor should delve deeper to understand its cause. If the investor is not satisfied with the outcome then she should avoid investment in such a company and look for other opportunities.
An investor must read the case of Amtek India Limited discussed in this article. Amtek India Limited presents a typical case of very low asset turnover in a highly capital-intensive business. Amtek India Limited is losing because of very low asset turnover, as the business consumes far more cash than it produces. This has led to the company increasing relying on debt to meet its cash requirements and as a result, its debt has increased whopping 33 times in last 10 years. You may read the complete analysis here:
(Image: financial performance of Amtek India Limited)
D) Convert Profits into Free Cash:
Converting profits into free cash is very important for any company as it is the cash, which is going to add value to the shareholders. It has been proved multiple times that companies go bankrupt not when they do not have assets, but when they run out of cash.
An investor should compare cumulative profit after tax (PAT) of last 10 years with the cumulative cash flow from operations (CFO) for the same period to assess whether the company is able to convert its profits into free cash.
CFO is derived from PAT after adjusting PAT for non-operating expenses like interest, depreciation and working capital changes.
If a company manages its working capital well, then ideally, its CFO should be higher than PAT because of the impact from adding back interest and depreciation. Therefore, when we notice that over 10 years CFO of a company is less than the cumulative PAT it has declared, then it should raise flags. It would indicate that the money is being stuck in working capital.
Money is most commonly stuck in working capital in the form of unrealized receivables from customers, which is indicated by increasing receivables days or in form on increasing inventory levels, which is indicated by decreasing inventory turnover ratio.
If the profits are stuck in working capital and not available as free cash, it would reduce the cash available for running day-to-day operations like payment to vendors, salaries to employees, interest & principal payments on bank loans and capital expenditure for new plants. In such a scenario, the company would have to rely on other sources of cash like equity or debt to fund its cash requirements. This would lead to either equity dilution, thereby reducing stake of existing shareholders or increasing debt levels, which would reduce profitability by higher interest costs and increase the risk of bankruptcy in case of tough economic scenarios.
Therefore, conversion of profits into cash is necessary for any company to survive over long periods. If an investor finds that a company is not able to do so, then she should study it in depth and in absence of any satisfactory explanation, she should avoid investing in such a company and look for other opportunities.
The above-mentioned case of Honda SIEL Power Products Limited also represents a case of company, which is not able to convert its profits into free cash.
E) Using Free Cash to Fund Future Growth:
An investor should always keep an eye on sources of funds that a company uses for its expansion plans or acquisitions. Ideally, a company should use the cash produced from its operations to invest in itself and produce further returns for its shareholders.
If an investor notices that the company is increasingly relies on debt to fund its growth, then it should serve as a cautionary sign. The spiraling debt might be due to non-conversion of profits into cash, which can be identified by the tools discussed above or due to over ambitious management, which is expanding faster than company’s resources permit. Both the scenarios are not good for shareholders.
Therefore, increasing debt levels should always signal warning to investors irrespective of the industry in which the company operates. Investors should focus on finding low or nil debt companies as debt free companies cannot go bankrupt.
The above-mentioned case of Amtek India Limited also represents a case of company, which has been increasingly relying on debt to fund its cash requirements and has seen its debt levels spiraling.
The premise of growth with sustained profitability, improving operating efficiency, conversion of profits into cash and then using this cash for future growth, remains the same for all businesses.
There can be many other aspects to access business performance; however, I believe that if an investor tracks the performance of any company on these five aspects discussed above, then she would be able to gauge the business performance of almost all the companies. She can separate out the good performers from poor ones and make better-informed investment decisions.
Different investors believe that companies in one industry would have different levels of ratios (say profitability or D/E ratio) than companies in other industries and an investor should give a little leeway while comparing two companies of different sectors. However, if an investor analyses business performance of one company over past, then the trend of change in its ratios when compared with previous years would indicate, whether company is showing improved business performance or not.
For example, an infra company might have higher debt than a Pharma company. However, if the debt level were increasing year on year without associated increase in sales and net worth, then it would indicate poor business performance for both infra and Pharma companies.
Therefore, I believe that if an investor makes a checklist of testing the past performance of all the companies presenting themselves as potential investment opportunities, on the parameters discussed in the article, then she would be able to segregate good performing companies from poor ones and make good investment decisions.
Let us summarize the parameters to provide a ready checklist:
- Sales Growth: consistent sales growth (CAGR) year on year, without occasional spikes.
- Stable or Improving Profitability:
- Operating Profit Margins (OPM) and
- Net Profitability Margins (NPM)
- Inventory Turnover Ratio,
- Days of Receivables Outstanding (Receivables Days) and
- Fixed Asset Turnover Ratio
I would like to know about your approach of analyzing the operating performance of companies. What resources do you use for gaining insights into companies performance? How has been your experience with those resources? Your inputs can be of help to the author and the readers alike. You may provide your inputs in the comments below or contact me here.
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