“Selecting Top Stocks to Buy” is a series of articles that focuses on the process of selection of stocks for investment. The current article in this series would focus on the financial analysis of a company along with important queries of investors on the same.
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”.
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)
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:
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 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.
*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.
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.
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 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.
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.
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.
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.
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.
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.
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.
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:
- Sales growth: Look for high and sustainable growth >15% per year. Growth rate of >50% are unsustainable.
- Profitability: Look for high and sustainable OPM and NPM. I prefer companies with NPM of >8%.
- Tax: Tax rate should be near general corporate tax rate unless some specific tax incentive are applicable to the company.
- Interest coverage: Look for companies with interest coverage ratio of >3.
- Debt to Equity ratio: Look for companies with low/nil debt. Preferably D/E <0.5
- Current ratio: Look for companies with CR >1.25
- Cash flow: Positive CFO is necessary. It’s great if CFO meets the outflow for CFI and CFF.
- 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:
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.
Let us now discuss some of the important queries asked by investors on different aspects of financial analysis of companies:
Investors Queries: Financial Analysis of Companies
How to interpret different scenarios of revenue growth and profit growth?
After studying a few results of some companies which I track, 2-3 points pop up in my mind. Comparing year on year:
- Revenue growth was flat or very low but the profitability went up. In notes to accounts, the company said that it is due to better product mix.
- Revenue growth was good and still profitability went down. Obvious reason was the insufficient internal cash generation and as a result, the company had to take a lot of debt. The high debt had a lot of interest cost, which affected the net profits.
- Revenue grew but profits grew faster. Definitely, there are some new advantages to the business, which are helping the company.
I understand that the case 3 is the best out of the three. The case 2 should be avoided and the Case 1 needs more analysis. This is because there is a limit to which one can cut costs and keep bottom line on an upward trajectory.
Sir my case in point is Globus Spirits Ltd.
In the last full year, the net profit (PAT) was ₹9 cr. The PAT was suppressed because of heavy capacity addition done by the company in the last 2 years, where it faced lot of issues. However, the company is now coming out of these issues.
In Q1-FY2018 sales grew at 0%. However, the PAT jumped by an extraordinary amount of 2-3 times to ₹7 cr.
The price to earnings ratio (PE ratio) of Globus Spirits Ltd is 31, which does not offer any margin of safety. However, I am comparing its PE ratio to the industry.
My question is, ideally, how long the cost-cutting measures are sustainable if revenue is not growing.
Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.
Cost cutting measures are usually an ever-ongoing effort. Once a company achieves maximum efficiency in existing processes, then due to changing business dynamics, some new processes get added in the company. Thereafter, the quest to cut costs on these new processes start.
As a result, we believe that it is difficult to see the company/business as an organism in steady state. Investors may not assume that a company can keep on focusing only on cost reduction and therefore that one day the company can achieve the stage of maximum cost efficiency.
To summarise, a company will keep on shuffling intermittently between all the three scenarios described by you. At any point of time, the company may be undergoing through either one or more than one of the three scenarios described by you.
Therefore, having an opinion about any company only based on what it is facing/doing currently, may not give the true picture of the company under “Peaceful Investing” approach. Hence, understanding the evolution of the company over long periods (>= 10 years) and observing how it behaved under different circumstances during these periods is essential to make any final opinion.
All the best for your investing journey!
Dr Vijay Malik
Should an investor invest in companies, which are not growing?
I have recently completed your peaceful investing online course. It has really added a lot of value to my analysis. Thank you for making such an amazing course.
I have a specific query. I have come across a few companies, which have nil or very low sales growth but have very high operating profit margin (OPM) and net profit margin (NPM) of around 60% and 45% respectively. These companies do not have any debt and have positive free cash flows. e.g.: Selan Explorations (oil and gas), CARE Ratings etc. Their growth prospects are dull.
What to do in such cases? Does the share price go up even if sales are not increasing? The historical price charts do not say so. What is your opinion about it?
Thanks for writing to us!
An investor would appreciate that selection of stocks is always a case where one has to choose among the best available options. However, if none of the available options looks good enough, then she should not invest wait for better opportunities.
We prefer to invest in the companies, which have grown in sales & profits instead of the companies, which do not show such growth. Nevertheless, if we find that a company is not showing growth currently, however, its current stagnant sales are only because of temporary reasons, then we may go ahead and invest in such companies. E.g. companies whose sales price is linked with raw material (RM) prices and currently RM prices may be falling. In such cases, sales may not grow for some time. However, it is usually a temporary phase. This is because the sales growth will revive when RM prices will increase in the future.
If an investor is not willing to wait and wants to invest her money urgently but finds that none of the companies with good growth in sales and profits is available cheap. Then, the only option in front of her may be to let go of such companies, which are showing sales growth but are currently available at expensive valuations. In such circumstances, she may choose to invest in companies, which are not showing sales growth but are otherwise fundamentally very strong and meet all the other parameters of the checklist. While investing in non-growth companies, the investor should keep in mind that over long periods, growing companies are expected to do better than non-growing companies do.
Advised reading: Final Checklist For Buying Stocks
Nevertheless, for an investor, conservatively funded fundamentally sound but non-growing companies may still be a better option than companies, which are growing at the cost of financial discipline. This is because the companies, which grow beyond their inherent capability (Self Sustainable Growth Rate SSGR) and in turn fund their growth by raising a huge amount of debt, face higher bankruptcy risk. In current times, many such companies, which relied on debt to fund their growth, are currently undergoing bankruptcy proceedings under NCLT.
Therefore, we believe that whether an investor invests in growing or non-growing companies, she must make sure that it meets all the other parameters like financial discipline, management analysis etc.
We believe that many factors other than the company’s performance may affect the share price movement for any company. Therefore, we would not be able to provide any views on the historical stock price movement of stocks.
Hope it answers your queries.
All the best for your investing journey!
Dr. Vijay Malik,
How to check whether a company has raised more equity in the past?
How to check whether debt reduction is done by the company from raising equity?
How can we conclude that debt reduction was done by using its profits generated and not by raising additional equity?
Also how do u get receivables days and payable days?
Thanks for writing to me!
To see whether the company has raised additional capital, the investor should analyse the share capital year on year. If there has not been any bonus share issuance, then the increase in share capital is due to fresh equity issuance.
Receivables days: you may learn it from this article:
Payable days: similar to receivables days but use cost of goods sold/ (average trade payables outstanding)
Dr Vijay Malik
How to calculate return on incremental earnings invested by the company?
I have one basic question. What parameter or group of parameters can be checked to know what is incremental return on the earning invested by the company into the business? I am only interested in earning invested. Company can take debt also and invest. However, I only want to screen for companies that are investing earning to give returns to investor.
Thanks for writing to us!
To find a solution, hypothetically, an investor may assume that every incremental earning is due to incremental investment. In such a case, increase in profits in any year may be assumed due to increased investment (due to debt or equity/earnings invested in business). Once an investor gets these figures, then she may get the return on the invested earnings.
However, this is a very simplistic assumption. This is because, the increase in profits may be due to earnings invested in previous years as in a case of a plant installed in previous years, which is not yet fully utilized i.e. capacity utilization less than 100%. Moreover, increased profits may be due to increase in price of company’s profits and not due to incremental investment of earnings.
Therefore, while assessing the return on incremental investment of earnings, an investor may need to keep in mind all the above scenarios.
Hope it answers your queries.
All the best for your investing journey!
Dr. Vijay Malik
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.
- To know about the stocks in our portfolio, you may subscribe to the premium service: Follow My Portfolio with Latest Buy/Sell Transactions Updates
- To learn our stock investing approach “Peaceful Investing” by videos, you may subscribe to “Peaceful Investing” Workshop-on-Demand
- To download our customized stock analysis excel template: Click Here
- Learn about our stock analysis approach in the e-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing”
- Read more company analysis in the e-book series: Company Analyses
- To register for our upcoming full-day “Peaceful Investing” workshop teaching in-depth fundamental analysis & portfolio management: Click Here
- To pre-register free/express interest for an investing workshop in your city: click here
- I have used the financial data of Vinati Organics Ltd, provided by www.screener.in and www.moneycontrol.com for this post.