How to do Financial Analysis of a Company

Modified: 22-Dec-20

The financial analysis aims 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. The 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 the potential for future growth.

 

Steps of Financial Analysis

The 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 a 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 the 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”.

Supreme Industries Ltd Screener Page

An investor can download the excel file of financial data of the company by clicking this link “Export To Excel”.

Once ready with the data, doing the financial analysis is a breeze. However, if an investor is not versed with using data analysis software like MS Excel, then he can use the manual 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.

Let us see an example of the financial analysis of a company, Supreme Industries Ltd as an illustration. Supreme Industries Ltd is the largest plastic goods manufacturer in India. The company manufactures plastic pipes, plastic furniture, cross-laminated films, protective packaging, composite LPG cylinders etc.

An investor may read our complete analysis of Supreme Industries Ltd in the following article: Analysis: Supreme Industries Ltd

 

(A) Analysis of Profit and Loss Statement (P&L)

i) Sales Growth:

The 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.

Supreme Industries Ltd has grown its sales from ₹2,469 cr in FY2011 to ₹5,511 cr in FY2020, which turns out to be a compound annual growth rate (CAGR) of 9% year on year.

Supreme Industries Ltd Sales Growth

An investor should prefer companies that have grown at least at a rate of inflation or more in past. One should note that very high growth rates e.g. 50% or more are unsustainable in long run.

 

ii) 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. Also, 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 a 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 Supreme Industries Ltd. (Please note that in the below table, some calculations might show some mismatch because of rounding off.)

Supreme Industries Ltd Financial Analysis Profit Margins

We can see that the operating profit margin (OPM) for Supreme Industries Ltd is almost stable at the levels of 14-16% during FY2011-2020. Similarly, the net profit margin (NPM) of the company is stable in the range of 8-10% over the years.

An investor should prefer companies that have stable or improving profit margin over the companies with declining or fluctuating profit margin where the company may see profits in some years and losses in other years.

Further advised reading: How Companies Inflate their Profits

 

iii) Tax:

A company with good accounting and corporate governance standards would want to pay all legitimate taxes to the government. In India, the 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 the tax payout history of Supreme Industries Ltd.

Supreme Industries Ltd Tax Payout Ratio

We can see that the company has been paying tax mostly at the rate of corporate tax. In FY2020, the tax payout ratio has declined because of a change in the corporate tax rate in India.

Payment of taxes at the rate of the corporate tax rate is a healthy sign. In case, an investor notices that a company has its tax payout ratio lower or higher than the standard corporate tax rate, then she should read the annual report of the company in detail to find out the reasons for the different tax rate. Most of the times, a lower tax payout ratio may be linked to the following reasons:

  • Tax incentives available to the company due to operations in SEZ etc.
  • Export incentives provided by the govt.
  • Tax-free income like interest on the investments done by the company in tax-free bonds.
  • Income that is taxed at a lower rate like short-term capital gains on investments like stocks and equity mutual funds etc.

Therefore, an investor should analyse the annual report in detail to find out the reasons for a lower tax payout ratio. In recent years’ due to the application of Indian Accounting Standards (IndAS), companies disclose a tax payout reconciliation table in the annual report, which reconciles the differences between the standard corporate tax rate and the actual tax payout ratio of the company in the profit & loss statement. This table is very helpful to understand any differences in the tax payout ratios of companies.

Advised reading: Understanding The Annual Report Of A Company

 

iv) Interest coverage:

Interest coverage indicates 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 the 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 an operating profit of at least ₹3 whereas their interest expense is ₹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 Supreme Industries Ltd. (Please note that some calculations might show some mismatch because of rounding off.)

Supreme Industries Ltd Interest Coverage Ratio

We can see that Supreme Industries Ltd has been maintaining an interest coverage ratio (C) of more than 8 throughout the last 10-years. In recent years, the interest coverage ratio is over 30.

While calculating the interest coverage ratio, an investor should keep in mind that the interest expense shown in the P&L statement is after deducting the capitalized interest. The capitalized interest is that portion of the total interest, which the company pays on the debt taken for construction of plant & machinery. Until the plant is operational, a company can capitalize interest on the debt taken for the construction of the plant. As a result, the interest expense in the P&L may not represent the complete interest outgo of the company in any year.

To mitigate this issue, in our analysis, we assume a sample interest rate and calculate the interest outgo for the company in any year based on that assumed rate. In the above table, Interest Outgo (F) is calculated based on an assumed interest rate of 10%.

Thereafter, we calculate the interest coverage ratio by dividing the operating profit with this interest outgo, which gives us a more realistic figure of the interest coverage ratio for the company.

An investor may read the following article to understand more about the capitalization of interest: Understand the Capitalization of Interest and Other Expenses

A high-interest coverage ratio for any company would indicate that the company 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 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 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.

 

(B) Analysis of Balance Sheet (B/S)

i) 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. The company uses its assets to produce goods & services that bring the sales revenue to the company. D/E ratio shows how much of the total funds employed by the company is its own (shareholder’s funds) and how much is borrowed from other lenders. D/E of 1 means that 50% of funds are brought by shareholders and the rest 50% is 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, the 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 Supreme Industries Ltd over time. (Please note that some calculations might show some mismatch because of rounding off.)

Supreme Industries Ltd Debt To Equity Ratio

We can see that Supreme Industries Ltd has been maintaining a debt to equity (D/E) ratio less than 1 consistently. The D/E ratio has declined over the years from 0.9 in FY2011 to 0.2 in FY2020.

Some investors like to use only secured or long term debt for calculating D/E ratio. However, we prefer taking total debt for calculating D/E ratio.

 

ii) 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 the next year. They include inventory that gets consumed and gets sold as a 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 the next one year and the short-term provisions.

The current ratio 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 Supreme Industries Ltd over time. (Please note that some calculations might show some mismatch because of rounding off.)

Supreme Industries Ltd Current Ratio CR

We can see that Supreme Industries Ltd has been consistently maintaining its current assets more than its current liabilities, which is a very healthy sign. Investors should look for companies that have a current ratio of at least 1.25 or more.

Please note that different investors use different inputs to calculate the current ratio. Some use investments as a part of the current assets whereas some other investors use provisions and customer advances as current liabilities. Therefore, as mentioned above, an investor may customise the ratio as per her preference.

 

(C) Analysis of Cash Flow Statement (CF)

This section provides details of the cash that a company has generated in the 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 a 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 Supreme Industries Ltd over time. Positive values mean cash inflow and negative values mean cash outflow. (please note that some calculations might show some mismatch because of rounding off.)

Supreme Industries Ltd Cash Flow Statement Analysis

We can see that Supreme Industries Ltd has been generating a good amount of cash from operations (CFO) year on year. CFO has increased significantly in the last 10-years from ₹170 cr in FY2011 to ₹537 cr. in FY2020.

We can observe that throughout the last 10-years, Supreme Industries Ltd was expanding its manufacturing capacities as reflected in the negative cash flow from investing (CFI). However, almost all the money for investment in the plant & machinery has been generated from its operations. This is because the cash inflow under CFO of the company has been consistently higher than the cash outflow under CFI.

As a result, an investor can appreciate that the surplus CFO left after taking care of the outflow under CFI has been used by the company to pay dividends to its shareholders as well as to repay its debt. In the last 10-years, Supreme Industries Ltd paid a total dividend (excluding dividend distribution tax) of ₹1,223 cr and reduced its debt by ₹73 cr from a total debt of ₹514 cr in FY2011 to ₹441 cr in FY2020.

While analysing the cash flow statement, an investor should be very cautious because there have been instances where companies attempted to inflate the cash flow from operations (CFO) by either not showing operating outflows under CFO or by showing debt inflows under CFO. The following article will help an investor understand more about the manipulations methods used by companies to inflate their CFO: How Companies Manipulate Cash Flow from Operating Activities (CFO)

 

(D) Parameters using a 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.

A 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.

 

i) Combination of P&L and B/S:

Some of the parameters that indicate the operating efficiency of a company use a mix of P&L and B/S like:

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 versed 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 the last few years with the cumulative CFO of the same period.

 

ii) 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 the 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 the 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 Supreme Industries Ltd over time.

Supreme Industries Ltd Comparison Of Net Profits And Cash Flow From Operations

We can see that Supreme Industries Ltd reported net profits of ₹3,333 cr. during FY2011-2020 and collected ₹4,215 cr. as cash flow from operations. This is a healthy sign for any company.

An investor may read our complete analysis of Supreme Industries Ltd in the following article: Analysis: Supreme Industries Ltd

 

Summary of Financial Analysis

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 the 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 parameters over the life of the 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. The growth rate of >50% is unsustainable in the long term.
  2. Profitability: Look for high and sustainable OPM and NPM. We prefer companies with NPM of >8%.
  3. Tax payout ratio: Tax rate should be near the general corporate tax rate unless some specific tax incentives are applicable to the company.
  4. Interest coverage: Look for companies with an 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 the 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 the USA or Satyam in India. Every investor must learn 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”

 

Should we reject companies with debt straightaway?

From the above discussion, an investor would notice that debt-free companies i.e. those with nil debt come across as the ones with a good and stable financial position. However, it does not mean that an investor should reject any company, which has debt on its books straightaway even if other parameters show that it has a fundamentally sound business model. The answer is, No!

This is because when an investor studies the history of business growth of companies, then she may notice that the company has taken debt to expand its business. It might have taken debt not because its existing business operations are running into losses or it is not able to convert its profits into cash flow from operations. However, it might have taken additional debt as it came across good business opportunities before its existing operations could repay its existing debt.

Many times, a large capex may be a result of excellent investment opportunities available for the company in its business. As a result, the company may be striving to grow its business fast to capitalize on the available opportunities.

In our attempt to analyse all the companies listed on India stock exchanges, when we looked at the financial performance of more than 2,800 companies above a market capitalization of ₹10 cr, then we came across many companies which had grown their business significantly and as a result, at times, they invested more than what they produced by their cash flow from operations. As a result, they had a negative free cash flow. However, at the same time, these companies rewarded their shareholders by the way of a significant increase in their share price because they kept the debt levels within control and improved their business strength.

Read: What I learnt from brief analysis of 2,800 Companies

7) Many large companies keep rewarding shareholders by way of increase in stock market price despite nil or negative free cash flow:

During the analysis of many large companies, I noticed that the stock price of these companies had witnessed a significant increase over the last 10 years where these companies had nil or negative free cash flow. In many cases, these companies had resorted to funding this cash flow gap by taking additional debt. However, in almost all the cases, the debt raised was small and within easily serviceable limits.

An investor would appreciate that the final investment decision by any investor is a result of a combination of all the parameters like financial, business, management and valuation analysis. Therefore, even in the case of companies with debt on their books, if the investor notices that they have strong performance on other parameters and their debt level is under control, then she may look at these companies for investment instead of rejecting them straight away due to negative FCF.

However, it is important for the investor would appreciate that in every scenario, the debt should be within easily serviceable limits.

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

I have just one question. The post does not mention about EPS. Do you 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 of ownership of existing shareholders remains the same.

However, the two would not remain the same if no. of shares increase due to the issue 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 issue 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 to as borrowing from the datasheet. 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 a 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 a little bit confused about 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 the calculation)
  • Similarly, in current liabilities, we add only short term borrowings and provisions or taken as a whole as mentioned in the balance sheet.

Sorry for bothering you by asking such a simple question. Looking forward to hearing 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 a 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 a bank, then debt to equity ratio would be 1 (i.e. 50/50).

Higher debt to equity means that the company has taken a 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 tells 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 the 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 the 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, the profitability went down. The 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 case 3 is the best of the three. Case 2 should be avoided and Case 1 needs more analysis. This is because there is a limit to which one can cut costs and keep the 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 a 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 in 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 the “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 maybe 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 Industries Ltd. 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.

The 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 the movement of the 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 the 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.

A 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 strategic 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 from 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 the data of 10 years, then I think the script which able to become multi-bagger had already become multi-bagger. I mean it had already gone up so much. How do you leave 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.

Some investors believe in investing in newly formed business: like seed funding, angel investors, venture capitalists.

There are other investors, who 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, some investors 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 multi-bagger, 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 the 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 a 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 a 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 the 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 the 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 the incremental return on the earning invested by the company into the business? I am only interested in earning invested. A company can take debt also and invest. However, I only want to screen for companies that are investing in earning to give returns to the 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, an increase in profits in any year may be assumed due to increased investment (due to debt or equity/earnings invested in the 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 an increase in the price of the company’s products and not due to the 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 a 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 an exceptional piece of work. I have a question regarding this blog, although I might find its solution later in your strategies mentioned 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 an example of companies where profits grew 5% but the share price declined >20% because the 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 has 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 the market expects high P/E stocks to grow at a fast pace. Or should be inverse this logic and say, the stocks which market expects to grow at a 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 an 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 the 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 the 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, the 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

 

Views about the possibilities of a turnaround of companies

Hello Mr Doc.

Hats off to you! You really doing excellent work. My question is on International Paper APPM Limited:

  • The ratios are not good at all.
  • But looking at International Paper buying a stake in Andhra Pradesh Paper Mills Limited (APPM) in 2011 for about $257 million.

Management’s view as per John Faraci, chairman and chief executive officer of International Paper:

Andhra Pradesh Paper Mills Limited is an excellent platform for International Paper to grow within the Indian paper and packaging markets. We believe that International Paper’s global operations and technical expertise can accelerate that growth and create value for customers as well as International Paper and Andhra Pradesh Paper Mills Limited shareholders.

What is your take on whole paper and packaging market?

Some ratios:

  • Return on equity last 10 years 2%.
  • Stock is trading at 3.15 times its book value
  • Contingent liabilities of Rs.583.82 Cr.
  • The company has delivered poor growth of 11.70% over the past five years

I am not interested in past results. But can the management turn around the company in the next decade?

What is your take on this company?

Author’s Response:

Thanks for writing to me!

You main query seems to be related to:

1) Outlook of the paper industry:

I am indifferent to the industry in my analysis. I prefer buying good performing companies in stagnant industries. Nevertheless, to understand more about the dynamics of the paper industry, an investor may read our detailed analysis of Century Textile & Industries Ltd, which is one of the largest paper manufacturers in India:

Read: Analysis: Century Textile & Industries Ltd

2) Turnaround of Andhra Pradesh Paper Mills Limited by International Paper:

Your guess is as good as mine. History is full of example for both good turnarounds as well as investors throwing good money after bad in hope of turnarounds and finally burning their fingers. However, instances of failed turnarounds are more.

This is not to indicate that Andhra Pradesh Paper Mills Limited would not see the turnaround, but only that no one knows as of now. It is more of a speculative call.

I think that an investor should wait for the impact of new management to get reflected in financial results before taking any investment decision in this company.

Regards,

Dr Vijay Malik

 

Equity or Debt: What is the right way to raise money for companies?

Hi Dr Vijay,

If any company needs fund for its expansion, then apart from internal accruals, if it goes for equity dilution then it will not need to make additional regular repayments like when it needs to do if it takes debt. However, it will cause equity dilution. If it creates additional debt instead of equity dilution, then it creates a debt burden which will reduce its net profit margin (NPM).

So among these two ways: equity or debt which route is more detrimental to retail investors.

I was reading the project execution of Aksharchem (India) Limited (Read: Analysis: Aksharchem (India) Ltd). They have announced the capital expenditure of approx. ₹175 cr 5-months back. On their balance sheet, they don’t have much debt. And the internal accruals won’t suffice the funds’ requirements. Hence, among the two sources of additional funds: equity and debt option, the board has approved raising equity via QIP at a price of ₹816 and 5% discount. This is approx. 8% lower than CMP ₹850.

As per my understanding, it makes equity dilution for retail investors while containing the debt repayment burden for business, which it needs to pay regularly. So in the long run, it may benefit business and in turn, also benefit the investors.

Companies may choose the other option of raising debt without diluting equity if they have confidence in the business and want to keep investors’ interest intact.

I think that in this case, if the management is investor-friendly, then it will go for debt option because in any case, currently, they don’t have much debt burden. Please provide your inputs on my approach and whether I am missing anything.

Author’s Response:

Hi,

Thanks for writing to us and sharing your views.

Your reasoning is in the right direction.

Moreover, it might be one of the consideration by the management that the share price is at an all-time high and they might want to take the advantage of the same by raising equity at current high prices.

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

All the best for your investing journey!

Regards

Dr Vijay Malik

 

Can we assess the Quality of Assets on the Balance Sheet?

Dear Dr Vijay Malik,

Trust you are doing well!

I have been a passive reader of your blog over the last two years. My stock investing journey started three years back & the process of learning is going step-by-step.

Many people follow many investors investing style. I prefer to follow investing style of “Walter Schloss”. He is an American investor who had primarily invested in low Price-to-Book value companies. I follow the below screener criteria.

1) Price to book value <=1

Purchasing companies less than their asset value

2) Return on capital employed >=9 AND Average return on capital employed 5Years >=9

This article by Nemish Shah inspired me to include this criterion. It is taught from a banking perceptive. If the banks are lending companies, then they should be able to generate capital more than the savings rate).

3) Debt to equity <=1

Eliminate debt-heavy companies

4) Interest Coverage Ratio >=4

It is the caution from the middle-class mentality. A salaried person should spend 1/4th of his income paying loans and the same logic applies for companies.

5) (Operating cash flow 10years) >= (10*Average Earnings 10Year )

Operating cash flow for 10 years should be greater than the net profit for 10 years. This logic I had incorporated from your articles.

6) Unpledged promoter holding >=30

Do promoters have an interest in running the business or else we may face problems like L&T takeover of Mindtree.

7) Up from 52w low <=10

Is the stock hitting 52-week low?

8) Dividend yield >0

Do promoters think about shareholders?

9) Volume >=100

Is there any trading volume for the company shares?

10) Contingent Liabilities to Total Assets <=20 AND Contingent Liabilities to Total Assets > 0

I am weary for companies that have too many contingent liabilities. After Nirav Modi scandal, I guess this need to be viewed with a keen eye.

11) Net profit >0 AND

12) Cash from operations last year >0 AND

13) (Cash from operations last year > Net profit) AND

14) Debt <= Debt preceding year AND

15) Number of equity shares <= Number of equity shares in the preceding year

The above five qualitative aspects were taken from Joseph Piotroski score. On a 9-point ranking, do they qualify for five ranks at least? Of these, I personally like companies that reduce debt.

The above screener criteria are more of the process of eliminating companies that do not qualify.

Dr Vijay Malik, I would like to know how you evaluate a company based on its “Quality of Assets”. If you had published articles on this regard, on asset evaluation please let me know.

The idea behind “Quality of Assets” is to assess do we need to make certain adjustments to the balance sheet? For example, companies might be overstating their intangible assets on their balance sheet. This might inflate the balance sheet.

An example of this case is stated by investor Michael Price (click here).

With regard to fixed assets, the below example was quoted by Water Schloss.

“If you have two companies – one with a plant that’s 40 years old and another with a new plant – both plants are shown on the books. However, the new plant may be much more profitable than the old one. However, the company with the old one does not have to depreciate it. So he may be overstating his earnings a little bit by having low depreciation.”

PSU companies might have large parcels of land and building. Do you think they might be underestimating on the balance sheet its value? As an individual investor, I cannot estimate everything. Can we make reasonable assumptions?

I had read an article published by Dr Bruce Greenwald. He had discussed Asset Reproduction Value. Jae Jun from Old School Value had discussed this with an example.

Dr Vijay Malik, all I am trying to understand is with published financial statements & footnotes can I estimate the net worth of the company for the current time. Please let me know your thoughts on this.

Regards,

 

Author’s response:

Hi,

Thanks for writing to us!

You have rightly pointed out that in case of the balance sheet; it is very difficult for any investor to estimate the true worth of assets. It might be a result of the following reasons.

1) Historical valuation of assets like land etc.

2) A significant amount of interest capitalized during debt-funded capital expenditures in the past. Please note that capitalized interest increases the value of the asset on the balance sheet without any addition to the operational worth of the plant & machinery.

Further advised reading: Understand the Capitalization of Interest and Other Expenses

3) Other gimmicks played by management like tweaks in intangible assets, ever-greening of loans by financial institutions etc. An investor would remember that in the recent past, a lot of banks (both public and private) who earlier declared NPA levels of <2% were found to have actual NPA levels of >10% and even going up to 40% (e.g. IDBI Bank).

Further advised reading: Can we assess a Bank’s Financial Position from its Reported Financials?

Such attempts by companies make it difficult to assess the “Quality of Assets” of any company. As a result, we do not give a lot of weight to the parameters based on balance sheet like PB ratio, ROE, ROCE etc.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr Vijay Malik

 

At how many years of growth should one focus?

Which EPS should one use: Diluted EPS or Cash EPS?

Dear Dr Vijay Malik

Could you please help with the following questions?

  1. Does consistent earnings growth mean for 10 years / 5 years?
  2. Which earning is recommended to use Diluted EPS or Cash EPS?

Thanks,

Author’s Response:

Hi,

Thanks for writing to us!

1) Does consistent earnings growth mean for 10 years / 5 years?

We agree that investors should prefer analysing the growth patterns of the company over long periods (in this case 10 years) because then investors are able to observe the performance of the company at least over one complete business cycle.

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

2) Which earning is recommended to use Diluted EPS or Cash EPS?

Out of diluted and cash EPS, we prefer to use diluted EPS. This is because, in the case of cash EPS, investors tend to add back the depreciation. Adding back the depreciation inflates the profits. This is because, depreciation is recognition of those expenses, which the company had incurred previously to create fixed assets but it did not deduct them from P&L due to capitalization. Therefore, depreciation is a mere postponement of expenses from one financial year (when fixed assets were created) to another financial year (when depreciation is recognized). Therefore, investors should deduct depreciation in the analysis of earnings.

Therefore, we prefer diluted EPS to cash EPS.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr Vijay Malik

Follow-up Query: Should one take 10-years growth in all cases?

Dear Dr Vijay Malik

Is 10-year growth a good measure? It might happen that a bull market lasts for 10 years. In this case, we are missing out the performance of companies during bear markets. Is it right?

In addition, how should one analyse the companies that are on the verge of turnarounds?

Thanks,

Author’s Response:

Hi,

Thanks for writing to us!

You would appreciate that the general rules are for guidance. In specific cases like the one mentioned by you for a bull market for 10 years, the investors may adjust their analysis accordingly.

We do not focus on turnarounds; therefore, we are not the best person to guide you on this matter.

All the best for your investing journey!

Regards

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 a stock. You may write about your experiences and learning in stocks markets in the comments below.

P.S.

 

DISCLAIMER

Registration status with SEBI:

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

Details of financial interest in the Subject Company:

Currently, I do not own stocks of the companies mentioned above in my portfolio.

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2 thoughts on “How to do Financial Analysis of a Company

  1. Sir, why do we compare and expect cumulative pat and CFO should be nearly equal in longer period? Because PAT considers interest and depreciation which CFO ignores it. So how can they be equal?

    • Hi Vaibhav,
      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.
      We request you to go through all the details including answers to the queries at the following article, which will help you in understanding it better: https://www.drvijaymalik.com/2017/05/understanding-cash-flow-from-operations-cfo.html
      After reading all the details on this article, if you still have queries, then feel free to write it alongwith the learning that you got from the above article. We will be happy to provide our inputs to your new learning.
      All the best for your investing journey!
      Regards,
      Dr Vijay Malik

Get FREE 3 e-books with 45 Companies Analysis

Free Investing Ebook Case Studies Peaceful Investing

Learn detailed fundamental analysis by reading case studies in these e-books:​

1. Company Analysis: Vol. 1
2. Company Analysis: Vol. 2
3. Case Studies: Applying Peaceful Investing Approach

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Get email updates of our articles