How to do Financial Analysis of a Company

Modified: 03-Jul-20

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.

 

Steps of Financial Analysis

Financial analysis consists of studying three paramount sections of the annual report and analyzing them in detail. These three sections are:

  1. Balance Sheet (B/S),
  2. Profit & Loss statement (P&L) and
  3. 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:

  1. Ratios and 
  2. 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”.   

Vinati Organics Ltd 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)

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:

Vinati Organics Sales 2005 2014

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. In addition, we do not include non-operating/other income while calculating operating profit.

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.

Vinati Organics Profit Margins 2005 2014

*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.

Further advised reading: How Companies Inflate their Profits

 

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.

Vinati Organics Tax Payout Ratio 2005 2014

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.

Vinati Organics Interest Coverage Ratio 2005 2014

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.

Vinati Organics Debt To Equity Ratio 2005 2014

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.

Vinati Organics Current Ratio 2005 2014

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.

Vinati Organics Cash Flow Statement 2005 2014

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).

Further advised reading: How Companies Manipulate Cash Flow from Operating Activities (CFO)

 

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.

Vinati Organics Cumulative PAT Vs Cumulative CFO 2005 2014

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.

Further advised reading: How Companies Inflate their Profits

 

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”

Let us now discuss some of the important queries asked by investors on different aspects of financial analysis of companies:

 

Investors Queries on Financial Analysis

How to calculate operating profit?

Hats off to you for the analysis and also giving your work to the public. Makes a learner’s life so much better.

Sir, I would like to know how you calculated the operating profit for the latest financial year (March 2017). The revenue for NOCIL was 742 crores. (From operations, excluding other income). Expenses are around 600 crores. Profit before tax is 150 crores.

Read: Analysis: NOCIL Ltd

Operating profit (EBIT): I added back the finance cost of 2.22 crores so I got the operating profit of 153 crores. But your worksheet shows an EBIT of 159 crores. So I would like to know where I am going wrong. What other expenses are u excluding?

Thanks in advance.

Author’s Response:

Hi,

Thanks for writing to us! We are happy that you found the article useful.

We calculate the operating profit from the data provided by Screener by factoring in the following expenses from the sales income/operating revenue:

  • Raw Material Cost
  • Change in Inventory
  • Power and Fuel
  • Other Mfr. Exp
  • Employee Cost
  • Selling and admin
  • Other Expenses

To reconcile these items in the screener export to excel data sheet with the annual report, we request you to refer to the following article:

Read: How to Use Screener.in “Export to Excel” Tool

Reference to this article and using the Screener data will help you.

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Tracking Net Profit Growth vs EPS Growth

Hi Vijay. I have been investing from last 2 year. I have sent you a post. I liked your article and it is good. I too follow similar approach like this with free cash flows (FCF).

I have just one question. The post does not mention about EPS. Do u think that it is ok not to track EPS apart from Net profit?

Also, how do track whether profit is increasing but equity getting diluted (may not be for this case).

Would be great full if you clarify.

Thanks.

Author’s Response: 

Thanks for writing to me! I am happy that you liked the article.

If there is no equity dilution year on year then EPS growth and net profit growth would represent one and the same thing, whether the no. of shares remain the same or increase due to split or bonus shares. In such cases, the percentage ownership of existing shareholders remain the same.

However, the two would not remain same if no. of shares increase due to issual of new shares which reduces the percentage shareholding of existing shareholders. In such cases from investor’s perspective, EPS growth would be more pertinent than Net Profit Growth.

However, in both these cases, net profit would keep retaining its significance in terms of profitability margins and the attractiveness of the business.

Read: How to do Financial Analysis of a Company

You can assess the dilution impact by looking at the share capital of the company. If share capital has increased then you should explore whether the same is due to bonus shares or issual of new shares.

Hope it helps!

 

How to calculate total debt; the role of Current Maturity of Long Term Debt (CMLTD)

Hello Vijay,

I had downloaded your Excel template that is useful for my analysis thank you for that.

Read: Download Dr Vijay Malik’s Screener.in Stock Analysis Excel Template

I have few things know about your excel template, as per your excel template total debt is referred as borrowing from the data sheet. Borrowing means (long-term borrowing +short term borrowing)? Or anything else I need to add? If it is only long term + short term borrowing then as per balance sheet for 2014 it should be ₹69cr and 2015 it should be ₹49cr but in our template, it is showing ₹100cr and ₹63cr. why is it so? I have referred many company annual reports and I have the same error.

Please clarify

Regards

Answer:

Hi,

Thanks for writing to me and subscribing to the premium services of drvijaymalik.com!

Total debt includes:

  1. Long term debt
  2. Short term debt and
  3. Current maturity of long-term debt (CMLTD), which is included in the section “Other current liabilities (OCL)” in the balance sheet.

An investor would find the amount of CMLTD when she reads the detailed notes/schedules, which provide the breakup of OCL.

Once the investor adds up LTD + STD + CMLTD, then the correct amount of total debt would be arrived at.

Read: Understanding the Annual Report of a Company

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

What should be the preferred level of debt to equity ratio

Vijay Sir,

Why do you think the Debt to Equity ratio should be less than 50%? If the company gets the long term loan on the cheapest rate, it would be beneficial for the company to finance its long-term projects. Financing the projects with borrowed money than Equity is not expensive for the company?

Author’s Response:

Hi,

Thanks for writing to me!

The stock investing approach along with the preferred investing parameters differ from one investor to another. A market is a place where different investors with different investing approaches meet, which results in a trade with two investors taking opposite decisions (buy & sell) with the same information available to them.

I prefer to invest in companies, which have as low debt as possible, preferably debt free. An investor would appreciate that if the debt is taken, then a fixed liability of making interest and principal repayments falls upon the company, which needs to be met irrespective of the business/company performance. Many times, such liabilities lead to the companies selling their assets in tough times and in infrequent situations, companies face bankruptcy as well.

Moreover, the probability of manipulating books to show good performance increases, when the company has debt on its books and it needs to meet the performance conditions stipulated by lenders.

All these factors become almost irrelevant, though not non-existent, when a company does not have any debt on its books, which lends stability to the business approach as well as peace to the investor.

Read: How to do Financial Analysis of Companies

However, as mentioned above, the investing approach is unique to each investor. Therefore, in case any investor believes that any company, despite having high debt, is being run by good management that would use the additional funds in a very good manner and this level of debt would not pose any risk to the company and the investors, then she may go ahead with her conviction.

Read: Choosing the Stock Picking Approach Suitable to You

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr Vijay Malik

 

How to calculate Debt to Equity Ratio and Current Ratio

Hello,

Dr. Vijay Malik I first want to commend you for sharing your knowledge with us. Your site is goldmine for beginners. You are able to explain everything in such a simple format that everything appears easy.

Query: Since balance sheet presentation has changed, so I am little bit confused on how to calculate D/E ratio and current ratio (CR), probably due to non-accounting background.

For calculating the debt of a company do we have to take all items mentioned in non-current and current liabilities?

  • Noncurrent liabilities: Long term borrowings, Net deferred tax liabilities, Other Long term liabilities, long term Provisions.
  • Current liabilities: Short term borrowings, trade payables, other current liabilities, short term provisions
  • Or just long term borrowings, short term borrowings and short term provisions only

While calculating Current Ratio:

Should we take all items mentioned in current assets and liabilities?

  • Current assets: Inventories, Trade receivables, Cash and cash equivalents, Short term loans and advances, other current assets (confused about whether current assets must be included in calculation)
  • Similarly in current liabilities we add only short term borrowings and provisions or taken as a whole as mentioned in balance sheet.

Sorry for bothering you by asking such simple question. Looking forward to hear from you.

If you don’t mind can u please explain all these items included in liabilities and assets in simple terms.

Thank you

Author’s Response:

Dear,

Thanks for your feedback & appreciation! I am happy that you found the articles useful!

Finance is a very versatile field which allows users to tweak the ratios as per their preferences. There is no right or wrong way of calculating the ratio until the time the investor understands what are the individual items which are becoming part of the ratios. This is the primary reason that we notice different investors using their own preferred or custom made ratios to analyse stocks.

You may try using different combinations of items as part of calculating D/E or CR and see which ratio formula works for you the best.

Let me tell you how I prefer to calculate D/E and current ratios:

D/E: (Long term debt + short term debt + current maturity of long term debt shown under other current liabilities)/Shareholder’s funds

Current ratio: (Cash & equivalents + current investments + account receivables + inventory)/(trade payables)

An investor may tweak these ratios as per her preferences.

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Vijay

 

What is the difference between debt to equity and debt to profit ratios?

Premier Explosives Limited:

  • Market Cap: ₹247.11 Crores
  • Current Price: ₹278.90
  • Book Value: ₹66.31
  • Stock P/E: 36.66
  • Dividend Yield: 0.76%
  • Stock is ₹10.00 paid up
  • Listed on BSE
  • 52 Week High/Low: ₹329.70 / ₹64.30
  • Sales growth 7Years: 11.73%
  • Price to Earning: 36.66
  • Debt to equity: 0.18
  • Debt to Profit: 1.92%
  • PB X PE: 154.34

Sir, I am learner and I want to know about

  1. Difference between Debt to Equity & Debt to profit
  2. PB*PE is 154.34 more than 22.5

How do all these parameters impact the stocks?

Author’s Response: 

Thanks for writing to me!

Debt to Equity:

It is a ratio which indicates out of money invested in total assets of a company, how much is put in by the shareholders and how much is taken as loan from outsiders like banks. If a company as assets of ₹100 and shareholders have put in ₹50 and balance ₹50 is taken as loan from bank, then debt to equity ratio would be 1 (i.e. 50/50).

Higher debt to equity means that company has taken high amount of loans than their own money to fund the assets. It increases risk, as lenders will ask their repayment as per schedule even if the company does not do well in any year. Then the company might have to sell assets to pay its lenders.

Debt to Profit:

This ratio tell you how much is the debt level when compared to profits. As a company has to pay its debt from its profits, therefore, higher debt to profit levels indicate high risk due to the same reasons as discussed in debt to equity ratio section.

The debt to profit ratio calculated above seems to have an error. The debt of Premier Explosives Ltd (PEL) at March 31, 2014 was ₹10cr. and profit was ₹9 cr. So the ratio would have been 10/9 = 11.11

P/E*P/B of 154.34 indicates that the stock is very highly priced, and therefore, is very costly. Benjamin Graham has suggested that an investor should not buy stocks which have P/E*P/B more than 22.5.

You should read Benjamin Graham’s book “The Intelligent Investor”. It is a very good book and advisable to read for all the investors.

You may read my review of The Intelligent Investor here:

Book Review: The Intelligent Investor

Hope it helps to answer your query.

 

How to analyse high current ratio of companies?

Hi Vijay,

While analyzing a company, the current ratios were found to be within 4 to 8 for the past 5 years. Does it mean that the company is having too much inventory or they were not properly investing their excess cash to get more out of the business?If yes, is it a red flag for investing in that company? Your valuable advice will be helpful.

Thanks,

Author’s Response: 

Thanks for writing to me.

It can be any of the two situations mentioned by you.

To find out the real cause of higher current assets, you should see the breakup of current assets in the annual report of the company and then try to analyse the trend in different components of current assets (e.g. inventories, current investments, trade receivables, short term loans & advances etc.).

Only upon the granular analysis of current assets, you would be able to find out the real reason. It can be that the company is selling goods but not able to collect money from buyers, therefore, trade receivables would be increasing year on year in relations to sales amount.

I suggest that you should study the annual reports and analyse composition of current assets year on year.

The following article on analysing operating performance of companies would help you in your analysis:

How to Analyse Operating Performance of Companies

Hope it helps.

 

How to interpret different scenarios of revenue growth and profit growth?

Dear Sir,

After studying a few results of some companies which I track, 2-3 points pop up in my mind. Comparing year on year:

  1. 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.
  2. 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.
  3. 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.

Gurjeev Anand

Author’s Response:

Hi Gurjeev,

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!

Regards,

Dr Vijay Malik

 

Should an investor invest in companies, which are not growing?

Hello sir,

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?

Regards,

Author’s Response:

Hi,

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.

Advised reading: Finding Self Sustainable Growth Rate (SSGR): a measure of Inherent Growth Potential of a Company

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.

Read: How to do Management Analysis of Companies?

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!

Regards,

Dr. Vijay Malik,

 

Using EBITDA growth instead of sales growth while analysing stocks

Dear Sir, I have no words to describe the job you have done in analysing Emmbi. I too am an investor in Emmbi and it has opened my eyes too.

Read: Analysis: Emmbi Industries Limited

However, I have two very basic fundamental queries, may not be connected to Emmbi per se.

First query is, why we attach so much importance to Sales Growth. To me sales growth in terms of rupees is misleading. Prices of raw material can go down. So sales in terms of money can show a dip. If we take Emmbi as an example, crude oil prices came down from 120 dollars to 40 dollars and now is in the 50s, hence Emmbi’s sales growth does not appear great. As per me we should see the EBIDTA growth, not sales growth. This captures the company’s ability to do business even during a downturn. EBIDTA is agnostic of raw material and finished product prices.

I will be highly obliged if you can give your views to my queries.

Author’s Response:

Hi,

Thanks for writing to me! I am happy that you found the article useful.

You’re right that an investor may use EBITDA as it would remove the impact of movement of sales price, if linked to raw material prices. Sales value being more intuitive and being readily available at multiple publically available databases as well as being subject to filters in multiple screeners is being used. However, if an investor wishes to use EBITDA, then she might use it.

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

How long history of financial data should be analysed for a company?

My query is why we should take 10 years as the basis for cash flow analysis. Why not 5 years. For example, Emmbi was making very low margin high competition HDPE bags. Only from 2012-13 did the company started making higher margin products. So if we go back in history when the company was not doing well and use those numbers in our calculations, we may draw an incorrect conclusion.

Related Query:

Hello Doctor,

I have customized my excel sheet by calculating 5yrs free cash flows (FCF), 5yrs operating cash flow, 5yrs NPAT.

I want to know that if I do not take CFO and Capex of last ten years, then will it make any difference to my results.

Also, I have calculated FCF for one year.

Will my process of calculating results only for 5 years instead of 10 years as yours distort the results for interpretation?

The reason for doing the above things is that I came to know during my analysis that in Screener the data for before 2012 was not matching for some of the companies. Please tell me if I am doing something wrong?

Regards,

Author’s Response:

Hi,

Thanks for writing to us!

The length of the time for which an investor should analyse the data is a personal preference of the investor. An investor may choose the timeline for which she is comfortable.

10 year parameter is a starting point for the analysis. However, as an investor reads more about the company, then she would continue to learn more about the specifics of the company and its different strategy decisions. The investor may then tweak her parameters accordingly. Moreover, we prefer to analyse as much historical data as is available whether it is 10 years or more than 10 years.

We prefer to analyse the data for the longest possible time for which it is available. Past financial data of 10 years is readily available in downloadable Excel format from different sources. Therefore, we use analysis of 10 years of data for any company which we assess.

Further Reading: Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

The results and conclusions may differ with changing the time frame of the data.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Related Query

Hello Sir,

As I know your analytical approaches that we should watch at least past 10 years track record of the company, but sir, if we take back 10 years back then I think the script which able to become multibagger already became multibagger I mean already went up so much , how are u left this sir, please explain. thanks doc

Author’s Response:

Hi,

Thanks for writing to me!

There are different investors in the market, who specialize in investing in companies at different stages of their life cycle.

There are some investors who believe in investing in newly formed business: like seed funding, angel investors, venture capitalists.

There are other investors, which invest in businesses that have seen the light of the day and have a history of operations of a few years like private equity funds.

Then, there are investors who invest only in large established companies and prefer dividends and safety of capital.

It is, therefore, advised that an investor should find out her own preferred area of investing and search for companies accordingly.

In case, an investor believes that a company with 10 years of good performance would have already become a multibagger, then she should focus on companies, which have a shorter period of good performance.

Read: Choosing the Stock Picking Approach Suitable to You

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Should we factor in capacity utilization level before interpreting net profit margin (NPM)

Vijay, we have seen that as the utilisation of a plant increases, operating leverage ensures higher profitability meaning net profit margin (% of sales) increases with plant utilisation. Whereas at lower capacity utilisation the net profit tends to be lesser.

My doubt: Since Net Profit margin is an indicator of the industry viz, monopoly, duopoly, highly commoditised, etc. at what level of capacity utilisation should one consider Profit Margin level

Author’s Response:

Hi,

Thanks for writing to me!

We do not consider net profit margin linked to industry. This is because within any industry, the NPM Of players differs by a huge margin.

We believe that if an investor is worried about year on year variations in the NPM, then an average of 3 years of NPM should work fine. Rest an investor may use any other criteria and check whether it works.

Read: How to do Financial Analysis of Companies

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Follow up query 

Vijay, I think my query has not been understood. What I mean is suppose a plant is running at 20% utilisation, then it may have 8% margins. As plant utilisation increases, to say 60% and then 85%, NPM will also increase to say 13-15%.

NPM normally indicate the nature of the industry. Highly competitive and commoditised businesses have very low NPM say 5-7% and as monopolistic businesses / Moat businesses may show up to 25% NPM.

My query: At what % of plant capacity utilisation can one take the NPM for that business?

Author’s Response:

Hi,

Thanks for writing to me!

As rightly mentioned by you, the spreading of fixed costs over larger volume of goods as the capacity utilization increases, would lead to improving NPM over time.

I do not have any clear cut answer as to at what capacity utilization one should take ideal/sustainable NPM.

As mentioned earlier, I prefer to take an average of last 3 years of NPM, which takes care of changing capacity utilization. Alternatively, an investor may take NPM at the capacity utilization levels, which the company has been able to achieve in the past.

Moreover, an investor may focus more on OPM, which is not impacted by expense of plant costs like depreciation and the funding costs like interest expense.

Hope it clarifies your queries!

All the best for your investing journey!

Regards

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?

Dr. Malik,

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?

Author’s Response:

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:

How to Analyse Operating Performance of Companies

Payable days: similar to receivables days but use cost of goods sold/ (average trade payables outstanding)

Regards,

Dr Vijay Malik

 

How to calculate return on incremental earnings invested by the company?

Sir,

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.

Author’s response:

Hi,

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!

Regards

Dr. Vijay Malik

 

How to calculate Retained Earnings

Dear Vijay, retained earnings is the money which the company puts back in the business. So shouldn’t capital expenditure be deducted along with dividend paid because that’s also an expense right?

Further, shouldn’t depreciation and amortization be added back to PAT while calculating retained earnings? (I’m just a beginner)

Author’s Response:

Dear,

Thanks for writing to me!

1) Capital expenditure is done by the company from the earnings that it retains after paying out dividend. Therefore, capex is not deducted while calculating retained earnings.

2) Adding depreciation and amortization (DA) into PAT takes the investor towards cash flow from operations, whereas retained earnings is a profitability figure which factors in the DA expense as part of the capital expenditure the company did in the past years on its fixed assets. DA should be deducted while calculating retained earnings and should be added back while calculating CFO.

Read: Understanding The Annual Report Of A Company

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Vijay

 

Can we assess what growth rate the market is expecting for a company?

Hi Dr Vijay,

First of all thank you so much for enlightening us with such exceptional piece of work. I have a question regarding this blog, although I might find its solution later in your strategies mentioned but I thought it’s better to ask as I go along.

You mentioned in the article: Book Review – The Intelligent Investor by Benjamin Graham

“Graham advises the defensive investor against buying growth stocks as they are usually overpriced and carry high risk. Risk in growth stocks arises not from the fear that such companies would degrow in future, but from the risk that they might not grow as expected by markets. The book gives example of companies where profits grew 5% but the share price declined >20% because market had expected 10% growth.”

Please mention if in case we find a good company according to the selection criteria and have a good profit, how will we know what the market have expected for the share and how can we be cautious of such measures when we already have found a very good company by fundamental analysis.

Regards,

Author’s Response:

Thanks for your feedback & appreciation! I am happy that you found the articles useful!

Regarding your query:

I do not know of any way to know for sure, what the market’s expected growth rate from a company is. Most of the times, it is believed that market expects high P/E stocks to grow at fast pace. Or should be inverse this logic and say, the stocks which market expects to grow at fast pace, it assigns high P/E to them.

Therefore, the logic can be extended that market expects low P/E stocks to grow at a very slow pace, however, if any investor can find a company among the low P/E stocks, which is fundamentally good and is able to grow at a fast pace, then she can earn good returns when market recognizes its potential and assigns it high P/E.

Therefore, I would say that to allay the concerns highlighted by you, an investor should invest in fundamentally strong low P/E stocks. You may read more about my views in this article:

How to earn High Returns at Low Risk – Invest in Low P/E Stocks

Regards,

 

How to decide if the tax payout ratio of company is good for investors?

Hi Vijay,

Thank you for the insightful article.

I had a doubt regarding the 30%+ tax rate for the past 4 years. How is that a good thing from an investor’s point of view?

Thanks,

Author’s Response:

Hi,

Thanks for your feedback! I am happy that you found the articles useful!

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.

All the best for your investing journey!

Regards,

Vijay

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.

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