March 3, 2018

Interpreting NFAT levels, Does quality of borrower show on quality of lender, Should CFO and FCF be equal, Simplifying SSGR

www.drvijaymalik.com has a section dedicated to answering queries from readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. We have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to the following queries:
  • What is a good level of Net Fixed Asset Turnover (NFAT)?
  • Does the quality of borrowers reflect upon the quality of lender?
  • A simplified understanding of SSGR
  • Should a company have equal CFO and FCF?
  • Why some stocks have low P/E ratios?

Interpreting NFAT levels, Does quality of borrower show on quality of lender, Should CFO and FCF be equal, Simplifying SSGR



What is a good level of Net Fixed Asset Turnover (NFAT)?


My main Question is if a company is paying taxes properly, but not paying a dividend, has low debt, has low NPM & NFAT is high that is more than 2. Can it be a good investment?

I have gone through the majority of the recent NFAT articles. Actually, the company, which I was talking about, is White Organic Agro Ltd.

NFAT here is 173 so it can be clearly said that by using fewer assets the company is producing more sales, which is good. NFAT of two means company is using it Assets to generate sales of two times of its Assets.

It was my mistake to relate ROE with NFAT. It can also be said that since the company has not declared a dividend in the past so ROE looks depressed. If they would have declared dividend than reserves would have decreased & as a result ROE would have been high.

At present, I am only sticking to NFAT.

Interpreting NFAT levels, Does quality of borrower show on quality of lender, Should CFO and FCF be equal, Simplifying SSGR


Author’s Response:

Hi,

Thanks for writing to us!

When an investor would analyse the NFAT of many companies across different sectors, then she would notice that NFAT of most of the companies ranges below 10. A two digit NFAT falls within high ranges and must be accompanied by strong brands etc.

A three-digit NFAT is mostly found in cases where the fixed assets itself are not a significant determinant of revenue. E.g. in trading businesses or in services business where a company can increase its turnover by making additional traders/employees within the same building.

Therefore, we believe that when NFAT rises beyond the usual ranges, then the dependence on fixed assets loses significance.


All the best for your investing journey!

Regards

Dr. Vijay Malik


Does the quality of borrowers reflect upon the quality of lender?



Hi Dr Vijay,

It is always a good learning reading your analysis on management quality based on related party transactions.

One question. I was analysing Pincon Spirits; I found that banks are giving huge short-term working capital loans to Pincon despite stressed CFO and negative FCF. Most of the banks were regional banks. One among them was _____ bank (sic).

So is it right to form an opinion on the quality of a bank based on its disbursements made to such financially stressed company?

The reason I came up with this question is that I had formed investment rationale for _____ bank sometime back and I avoided it after analyzing Pincon.

Thank you.

Author’s Response:

Hi,

Thanks for writing to us. We are happy that you found the article useful. We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.

Different banks follow different lending approving mechanisms. In some cases, individuals may approve the loans. In such cases, some poor lending decisions may be a result of the decision of a few individuals. Therefore, might not be representative of the entire organization.

On the other hand, in other banks, the lending decisions may be centralized in certain authorities indicating general practices in lending. Therefore, it is difficult to have an opinion.

Moreover, it is very difficult to assess the lending quality of any bank by relying on the numbers reported by them. This has been evident from the results reported by banks in last a few quarters when suddenly a lot of NPAs have come up whereas earlier the asset quality was reported to be good.


Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik


A simplified understanding of SSGR




I tried to understand the formula. Kindly correct me if I am wrong.

The formula roughly translates into Fixed Assets - Depreciation + (Net Profits - Dividend Paid)/ Fixed Assets.

The crux of the formula is that if depreciation > (Net Profit - Dividend Paid), the company is bound to have a negative SSGR
  
Author’s Response:

Hi,

Thanks for writing to us!

You are right that the essence of the concept of SSGR and its formula is to compare the decline in fixed assets due to depreciation and then replenishment of fixed assets by retained earnings (PAT - dividend).

If the retained earnings are not able to replenish the impact of the reduction in fixed assets due to depreciation, then year on year net fixed assets will decline and the company would show negative growth i.e. negative SSGR.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik


Should a company have equal CFO and FCF?



Dear Dr Malik,

Appreciate your thoughts.

I have picked from one of your articles, mentioned by you saying, "One should rely more on FCF than CFO while analyzing cash flow statement."

As you have explained FCF = CFO - Capex, this helps us to mitigate the risk of companies trying to inflate earnings and CFO by capitalizing day-to-day operating expenses.

My understanding is to avoid the inflated earnings and CFO risk, so why do we not compare cPAT with cFCF.

Looking forward to your invaluable insight.

Kind Regards

Author’s Response:

Hi,

Thanks for writing to us!

We believe that the logic of using CFO-capex (i.e. FCF) to compare with PAT is correct in its limited context that it will provide adjustment in case management is capitalizing day-to-day operational expenses. However, as capex also includes genuine capital expenditure in plant and machinery, therefore, deducting entire capex, which might include expenditure on plant and machinery as well as capitalized operating expenditure by the management, if any, will unnecessarily penalize the company.

To have an analogy: PAT is like CTC of an employee, CFO is like take-home salary and FCF is the savings of the household after meeting the expenses. So PAT and CFO might be compared with each other but comparing PAT and FCF and expecting them to be equal may not be a prudent idea.


Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik


Why some stocks have low P/E ratios?



Dear Dr.

My keen interest is to know why the PE of any stock remains near 2-5 (very low) for several years despite good CFO and nice FCF%. For example Manaksia, Maithan Alloys etc.


Please guide.

Author’s Response:

Hi,

Thanks for writing to us!

The present P/E of a stock in the market is dependent upon the current stock price, which is a result of the cumulative impact of all the participants. There may be many factors apart from fundamentals of the company, which drive the behavior of market participants and thereby affect the market price and the P/E ratio.

Therefore, we are not able to give any opinion about the prevalent P/E ratio of any stock.


All the best for your investing journey!

Regards,

Dr Vijay Malik 

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DISCLAIMER


Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of any of the companies discussed above