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 operating efficiency 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.
The current article explains the basics of operating performance of companies along with the important parameters used in assessment of operating efficiency like net fixed asset turnover, inventory turnover, receivables days etc. The article provides further clarifications to operating performance analysis by providing answers to some of the most important queries of investors like:
- What is a good level of Net Fixed Asset Turnover (NFAT)?
- Why should investors be cautious while investing in companies with low net fixed asset turnover (NFAT)?
- Impact of depreciation on NFAT
- Correlation between Sales Growth and Net Fixed Assets
- Comparison of net fixed asset turnover (NFAT) and ROE/ROCE
- Impact of capital expenditure on operating efficiency and net fixed asset turnover (NFAT)
- How to search for sectors having asset light business model (Low NFAT)
Importance of Operating Performance Analysis
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.
Framework of Operating Performance Analysis
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 operating 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:
(Image: financial performance of Honda SIEL Power Products Limited)
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.
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 operating performance; however, I believe that if an investor tracks the operating 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 companies with good operating performance 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.
Operating Performance Analysis : A Checklist
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)
- Stable or Improving Operating Efficiency:
- Inventory Turnover Ratio,
- Days of Receivables Outstanding (Receivables Days) and
- Fixed Asset Turnover Ratio
- Conversion of Profits into Cash: Cumulative CFO should be higher than Cumulative PAT
- Using Free Cash to fund Future Growth: No spiraling debt levels.
Let us now address various queries of investors, which would provide further clarifications to the concept of operating efficiency of companies:
Investors’ queries on Operating Performance
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.
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!
Dr. Vijay Malik
Why should investors be cautious while investing in companies with low net fixed asset turnover (NFAT)?
First Read: Deep Industries Research Report
I get your point about asset turnover ratio being less than 1. But what about the fact that the assets which Deep Industries is creating, especially in gas dehydration, have a life of 20 years.
So, even though they may earn only 0.4 rs on every INR spent on capex, all of their Capex gets paid after 2 odd contracts and remember, 90% of their contracts are recurring. So, after all, capex is paid off, asset turnover ratio is not what you see it as right now.
What would you comment about that?
Thanks for writing to us!
Net fixed asset turnover indicates the capital intensiveness of any business with a low NFAT indicating that for business growth, significant new money needs to be invested in the company.
Let’s suppose the company purchases one unit of revenue generating asset e.g. a manufacturing plant or a rig or any other such asset for Rs. 100 cr. which as per NFAT of 0.4 gives revenue of Rs. 40 cr.
If the company plans to keep only this one unit with itself, then it may keep on generating revenue of Rs. 40 cr. for the life of the asset (say 20 years). However, to increase revenue it would have to purchase another revenue generating asset, which would entail an expenditure of Rs. 100 cr.
If an investor is ok with the company not doing new capex and limit itself to one revenue generating unit purchased in the past, then she may remain content that the company is generating Rs. 40 cr. every year without doing any more capex.
An investor may also need to keep in mind that an asset of Rs. 100 cr. may need anywhere between Rs. 5-10 cr. for maintenance every year. If the company is not able to generate this money in the profits from the Rs. 40 cr. being earned each year (requiring a profit margin of about 12.5% to 25%), then the said asset may not remain in useful condition for its entire life of 20 years and may become dysfunctional sooner.
The key essence is that low NFAT businesses are quite capital intensive and keep on guzzling cash on a continuous basis.
All the best for your investing journey!
Dr. Vijay Malik
Impact of Depreciation on Net Fixed Assets Turnover (NFAT)
Dear Dr. Malik,
- Regarding net fixed asset turnover ratio: if a company’s sales don’t increase for few years but the net fixed asset in decreasing due to depreciation charges, doesn’t this distort the Net fixed asset turnover ratio (NFAT will increase), instead should we calculate the gross fixed asset turnover ratio.
- How does a company calculate its net asset value and makes deletion and addition to it? Is the gross asset value adjusted first and then depreciation charges adjusted accordingly? e.g. if the company has gross assets Rs. 1000/-composed of few machines and land and it sells a machine at Rs. 50/- (bought initially at say Rs.100/- )then does the net gross asset comes out to be 1000-100+50 = 950 , and then depreciation charges adjusted to it. Or is it calculated entirely differently?
Thanks for writing to me!
1) Net fixed asset turnover represents a close approximation to the current value of the plant & machinery as it keeps on adjusting the decline in value by depreciation and the regular increase in investment as part of maintenance capex. We believe that it does a fairly good job in identifying the companies, which have an asset heavy business from the companies, which have an asset-light business. Moreover, NFAT can be readily calculated from widely available public sources of data like screener.
However, as finance allows investors to keep tweaking the ratios as per their preference, therefore, we advise that investors should keep on working with new ratios to see if the new ratios do a better job at differentiating companies. Therefore, we suggest that you analysis companies at gross fixed asset turnover and share your results & learning with the readers and author of drvijaymalik.com
2) We would suggest that you should read the fixed asset schedule/note to account in any annual report. Reading the detailed schedule containing the table of gross fixed assets including additions & deletions, accumulated depreciation and then arriving at net fixed assets would resolve your query. In case after reading the fixed asset schedule section of the annual report, you still have any query, then we would be happy to provide our inputs.
Correlation between Sales Growth and Net Fixed Assets
Thank you for your support once again.
Please confirm my understanding as per the above article.
If company wants to grow 25% in sales then net fixed asset turnover ratio also need to grow 25% from the previous year? Is it correct?
If company NFA is not growing 25% then company need to raise some capital from outside to meet the 25% sales growth. Is it correct?
Thanks for writing to me!
If company wants to grow sales by 25% and not invest in fresh net fixed assets, then it needs to improve the utilization of existing fixed assets by 25%. However, if it is willing to invest in new fixed assets, then assuming all other things remain constant, then it can increase sales by 25% by keeping same efficiency of fixed assets utilization/turnover ratio by creating 25% more fixed assets by additional investment.
If the company decides to create additional fixed assets to the extent of 25%, but it is not able to make sufficient money from its operations to invest in its plant, then it will have to raise capital from outside.
Hope it clarifies your queries!
All the best for your investing journey!
Comparison of net fixed asset turnover (NFAT) and ROE/ROCE
Sir, Is there any relation between net fixed asset turnover (NFAT) and ROE/ROCE? I understand that both are similar as one has topline and the other has bottom-line in the numerator (bottom line is proportional to top line with NPM as proportionate constant).
In denominator, one has fixed assets and other has equity (I understood both are similar as equity converts to fixed assets to generate sales).
Now in case of Ahmednagar Forgings Limited, as you described asset turnover is low but its ROE is high. How should we understand this? Is it because of high cost of acquisitions? Please enlighten me.
Thanks for writing to me! I appreciate your way of thinking and logical reasoning.
I would like to highlight 2-3 things to address your concern:
- NPM is not a constant. It keeps changing year on year. So in a year when sales are high, fixed asset turnover (FAT) would be high, but if in this year NPM is low, say due to high raw material prices, then ROE (NPM/Equity) would be low.
- Fixed asset may be funded by debt as well apart from equity.
- Low FAT and high ROE is typical of companies which use high debt and low equity to fund their assets. Inefficient use of large asset base would produce low FAT, whereas small equity base would show good ROE even at low profits.
This is one of the reason I believe that ROE is not a very relevant factor for investors. Read more about my views on ROE here:
Hope it clarifies!
Impact of capital expenditure on operating performance and net fixed asset turnover (NFAT)
God Bless you Vijay for giving back to the world.
When you say “invest in fixed assets to improve its plant & machinery/technology (leading to lower NFAT)”, you mean “leading to higher NFAT”?
Thanks for your kind words! I am happy that you found the article useful.
I mean to say “leading to lower NFAT”
NFAT = Sales/NFA
Therefore, when a company invests in fixed assets, then the denominator increases in value. However, the numerator, which is sales, take some time to pick up as it takes some time to find buyers for the new capacity and to reach optimal utilization levels of new capacity. Therefore, the numerator increases with a time lag. In the interim period of doing the capex and resultant increase in sales, the NFAT levels come down.
You may read the following article to understand more about NFAT and other operating efficiency parameters of companies:
Hope it clarifies your queries!
All the best for your investing journey!
How to search for sectors having asset light business model (Low NFAT)
My question: sectors in India having asset-light business model and how to search them in screener
Ratios to look into—
- High Fixed asset t/o ratio,
- Low debtor’s receivables days,
- High inventory t/o ratio,
- High creditors’ payable ratio.
Also having low investment in securities for emergency purposes and reasonable cash balance to meet working capital requirements.
Sectors according to me which is asset light are FMCG, pharma.
Waiting for ur inputs on this and what is ur criteria when u r doing research on a particular sector or stock.
Thanks for writing to me!
You may screen the companies by the following ratios measuring operating performance in screener to get the companies, which are asset light:
- Inventory turnover,
- Days of sales outstanding i.e. receivables days
Screener has ready built ratios for the above ratios.
For the asset turnover, you may create a custom ratio in screener as (netblock/sales).
I do not screen stocks based on asset turnover, however, I do look at it as one of the parameters while making the final decision.
All the best for your investing journey!
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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.