Operating Performance Analysis: A Simple & Complete Guide

Analyzing the 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.

The current article explains the basics of the operating performance of companies along with the important parameters used in the 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 an 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 a 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 reader 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 the 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 the 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:

1. Companies need to grow,
2. Maintain or improve profitability,
3. Operate efficiently,
4. Convert profits into free cash and
5. 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 the 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 an 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 the company’s operations as shareholder’s incremental contribution in the business.

Analysis of both OPM and NPM are important while analyzing the 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.

Let us see an example where the company, Sun Pharmaceuticals Industries Ltd has focussed on increasing its sales at the cost of profitability. While analysing Sun Pharma, an investor notices that the company has grown its sales at about 20% year on year over the last 10 years from ₹5,728 cr in FY2011 to ₹32,838 cr in FY2020. However, during this period, the operating profit margin (OPM) of the company has declined from 34% in FY2011 to 21% in FY2020.

During the same period, the net profit margin (NPM) of the company has declined from 32% in FY2011 to 11% in FY2020.

An investor may learn more about analysing the business models of the companies and identifying companies with improving, deteriorating and cyclical business models in the following article: How to do Business Analysis of a Company

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: (Sales / Average inventory at start and end of the year)

Many investors use the cost of goods sold (COGS) instead of sales in the numerator for calculating ITR. Financial analysis provides the investor with 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. A higher ratio indicates that a company is able to rotate its inventory faster and its capital is not stuck in inventory.

Advised reading: Inventory Turnover Ratio: A Complete Guide

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 a company and look for other opportunities.

Let us see the example of a company, Supreme Industries Ltd, which has seen its inventory turnover ratio (ITR) decline over the years. An investor notices that over the last 10 years, ITR of the company declined from 8.9 in FY2012 to 6.7 in FY2020.

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

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:

Receivable Days = (Average trade receivables at start and end of the year * 365) / Sales

Ideally, 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 the 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.

Further Advised Reading: Receivable Days: A Complete Guide

Let us see the example of a company, Sonata Software Ltd, which has faced delays in payments by its customers over the years. While analysing Sonata Software Ltd, an investor notices that its receivables days have increased over the last 10 years from 47 days in FY2012 to 74 days in FY2020.

An investor may read our complete analysis of Sonata Software Ltd in the following article: Analysis: Sonata Software Ltd

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:

Sales / Average of Net fixed assets at the start of the year and 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.

The 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 efficiently 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, the 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.

Further advised reading: Asset Turnover Ratio: A Complete Guide for Investors

Let us see the example of a company, Century Textiles & Industries Ltd, whose net fixed asset turnover ratio has declined over the years.

The company operated in a number of business divisions like cement, paper, textiles etc. All of these divisions were capital intensive. Moreover, the asset utilization efficiency of Century Textiles & Industries Ltd measured by net fixed asset turnover was declining over the years. Due to low efficiency, the company had to rely on debt to meet its funds’ requirements and as a result, by FY2018, the company reached a situation where it could not repay its debt. As a result, it had to hive off its entire cement business (>50% of sales) and one of its textile units (Rayon) to reduce its debt.

An investor must read the complete analysis of Century Textiles & Industries Ltd present in the following article:  Analysis: Century Textiles & Industries Ltd.

D) Convert Profits into Cash Flow:

Converting profits into cash flow 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.

Advised reading: Understanding the calculation of Cash Flow from Operations (CFO)

If a company manages its working capital well, then ideally, its CFO should be higher than PAT because of the impact of 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 the form of 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.

Let us see the example of a company, Mahindra and Mahindra Ltd (M&M) that has not been able to convert its profits into cash flow from operations over the last 10 years.

When an investor compares the net profit after tax (PAT) of M&M with its cash flow from operating activities (CFO) for the last 10 years (FY2011-2020), then she notices that it reported a total PAT of ₹37,909 cr and a negative CFO of ₹(3,175) cr during this period.

As a result, of cash losses by M&M during FY2011-2020, an investor would appreciate that it would have to raise debt to finance its day to day operations. Therefore, it does not come as a surprise to the investor when she notices that the debt of M&M has increased during FY2011-2020 from ₹17,047 cr to ₹82,567 cr.

Therefore, the 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.

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 relying on debt to fund its growth, then it should serve as a cautionary sign. The spiralling debt might be due to the 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 the company’s resources permit. Both scenarios are not good for shareholders.

An investor can refer again to the example of M&M discussed above where the company had a negative cash flow from operations of ₹(3,175) cr over FY2011-2020. The investor also notices that during this period, the company invested ₹46,106 cr as capital expenditure to increase its business. As a result, the company reported a negative free cash flow of ₹(49,281) cr during FY2011-2020.

It seems that all the money needed for capacity expansion has been funded from debt as the total debt of the company increased by about ₹65,500 cr from ₹17,047 cr in FY2011 to ₹82,567 cr in FY2020.

An investor would further appreciate that in the light of negative CFO and negative FCF, an investor would appreciate that all the dividends of more than ₹7,000 cr (excluding dividend distribution tax) paid by M&M to its shareholders over FY2011-2020 have come from the debt proceeds.

An investor should be cautious while taking the comfort of dividend payments from companies that fund it from debt due to negative CFO and FCF. This is because the dividend payments by the company may stop any time when the lenders realise that the company is facing challenges in repaying their interest/debt. Dividend payments to the shareholders and bonuses to the managements are the first things to cut when the lenders put curbs on companies.

Therefore, increasing debt levels should always signal a 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.

Conclusion

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 a good operating performance from the 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 the 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 an 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:

1. Sales Growth: consistent sales growth (CAGR) year on year, without occasional spikes.
2. Stable or Improving Profitability:
   • Operating Profit Margins (OPM) and
   • Net Profitability Margins (NPM)
3. Stable or Improving Operating Efficiency:
   • Inventory Turnover Ratio,
   • Days of Receivables Outstanding (Receivables Days) and
   • Fixed Asset Turnover Ratio
4. Conversion of Profits into Cash: Cumulative CFO should be higher than Cumulative PAT
5. Using Free Cash to fund Future Growth: No spiralling 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

Is it ok if a company has high receivables days but manages it with high payable days?

Hi Vijay,

Analysis: Torrent Pharmaceuticals Limited

Nice analysis on Torrent Pharmaceuticals.

There are a few points which I would like to bring to your notice. Although, the receivables are high; however, they are more or less balanced by high payables. The cash conversion cycle for the last five years are as follows FY15 (10.54); FY14 (3.25); FY13 (7.50); FY12 (-7.86); FY11 (17.68). Therefore, the efficiency of working capital is very good in my opinion. This is the reason they have been able to maintain high ROE (26-40%) in the last 5 years.

Moreover, if you look at their cost of debt then it falls between 5-7% in the last five years which again is very low. FY15 (175/2740 = 6.39%); FY14 (59/1132 = 5.21%) and so on. They might have raised cheap debt from abroad. This might be one of the reasons why they are keeping a high cash balance without retiring debt. Please post your opinion on the same.

Thanks and Regards,

Author’s Response:

Hi,

Thanks for writing to us and sharing your inputs. We appreciate the time and effort spent by you in the analysis of Torrent Pharma & sharing it with author and readers of drvijaymalik.com

Here are our views about the two points raised by you:

1) A company can maintain its working capital cycle/cash conversion cycle despite increasing receivables days by delaying payments to vendors. However, conceptually both rising receivables and payables are signs of financial strains. Payments should be done and collected within timelines. Long overdue receivables lead to bad debtors and long overdue payables lead to the withdrawal of good credit terms by vendors. However, the cash conversion cycle being a composite parameter is not able to highlight these issues.

This is one of the reasons that we do not prefer using composite parameters like the cash conversion cycle (CCC) and even return on equity (ROE) or return on capital employed (ROCE).

2) The cost of debt calculated by you is based on the interest expense shown in the P&L. Companies capitalize interest cost of capex as part of fixed assets/CWIP, which is not shown in P&L. We prefer using entire interest outgo (both P&L and capitalized amount) for estimating the interest burden of a company.

Understand the Capitalization of Interest and Other Expenses

Hope it clarifies.

Regards,

Vijay

Can high working capital be a competitive advantage (Moat)?

Read: Analysis: Divi’s Laboratories Limited

Hi Dr. Vijay,

Thanks for this analysis. It is really helpful.

I was really curious about two things on Divi’s Laboratories Limited:-

1. Working Capital – You rightly analysed, the Working capital is high compared to its peers. However, if we look at the realisations and the operating margins (way higher than the Industry), that easily makes up for the high working capital (P.S.- there is no debt on the Balance sheet). In fact, isn’t it a moat for the company? I think it is leveraging its balance sheet strength to command industry-best margins (for more than 10 years).
2. Management’s commitment towards the business- Two important aspects as far as management’s commitment is concerned can be: – A) Managements execution capabilities; 2) Making competitive moats for the company.

As rightly indicated by you, management had a superb track record in project execution. Second, its capability to keep the competition at bay for more than 10 years makes a strong case for management’s active involvement in the company’s business.

Your concern about the unlisted company is something very interesting.

PS- Help me if I am missing something.

Author’s Response:

Hi,

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

1) We believe that supplying APIs to branded generics manufacturers is a commodity business. We believe that in commodity businesses, profitability margins higher than peers should be looked with caution. Many corporate fraud cases had reported higher OPM than peers in businesses where no such significant competitive advantage existed. This is not to say that the presently analysed company is a fraud or on the contrary to say that it has a huge competitive advantage. This is to highlight that we believe that higher OPM than peers in a commodity business where your product is not much different than your peers, should be looked with caution and need to be analysed further.

We do not think that higher working capital is a moat. Let’s do a rough assessment:

• Divi’s Lab has receivables days, which is about 20-25 days higher than its peers and it has OPM which is about 37-40% whereas peers have margins of 20-25%.
• Looking solely at the above data, it can be inferred that the end customer is willing to pay about 15% extra for a higher credit period of 20-25 days.

We do not think that higher working capital in terms of higher credit period to customers is the moat here.

2) We would not be able to comment on the exact competitive positioning of Divi’s as it would require the understanding of the other vendors to their customers and Divi’s wallet share in those end customers.

However, we believe that API is not a very niche field and until some time back Chinese companies were the leading API manufacturers of the world. India is accustomed to importing the bulk of its API requirements from China.

We would need to wait for the outcome of the current USFDA issue to know whether the company resorted to cost savings by the way of bypassing prevailing/expected best practices.

Read: How to do Business Analysis of Companies

Hope we are able to address your concerns.

All the best for your investing journey!

Regards

Dr. Vijay Malik

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.

Author’s Response:

Hi,

Thanks for writing to us!

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

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

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

All the best for your investing journey!

Regards

Dr. Vijay Malik

Why should investors be cautious while investing in companies with low net fixed asset turnover (NFAT)?

First Read: Deep Industries Research Report

Hi Vijay,

I get your point about the 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, the asset turnover ratio is not what you see it as right now.

What would you comment about that?

Author’s Response:

Hi,

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 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!

Regards,

Dr. Vijay Malik

Impact of Depreciation on Net Fixed Assets Turnover (NFAT)

Dear Dr. Malik,

1. Regarding net fixed asset turnover ratio: if a company’s sales don’t increase for few years but the net fixed asset is 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.
2. 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?

Regards,

Author’s Response:

Hi,

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.

Read: Understanding the Annual Report of a Company

Regards,

Correlation between Sales Growth and Net Fixed Assets

Hello Vijay,

Thank you for your support once again.

Read: Analysis: Ahmednagar Forgings Limited

Please confirm my understanding as per the above article.

If a company wants to grow 25% in sales then the 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 the company need to raise some capital from outside to meet the 25% sales growth. Is it correct?

Please confirm.

Regards

Author’s Response:

Hi,

Thanks for writing to me!

If a 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 the 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!

Regards

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 the 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 the high cost of acquisitions? Please enlighten me.

Regards,

Author’s Response:

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 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.
• The fixed assets 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 reasons I believe that ROE is not a very relevant factor for investors. Read more about my views on ROE here:

Why Return on Equity (ROE) is not meaningful for Stock Market Investors!

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”?

Author’s Response:

Hi,

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!

Regards

Vijay

How to search for sectors having an asset-light business model (Low NFAT)

My question: sectors in India having an 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.

Author’s Response:

Hi,

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!

Regards,

Vijay

How are trade payables a source of interest-free funding for a company?

Read: Caplin Point Laboratories Research Report

“At March 31, 2017, Caplin Point Laboratories Limited had an inventory of ₹22 cr. and trade receivables of ₹33 cr. This working capital requirement of ₹55 cr. (22+33) has been sufficiently funded by the outstanding trade payables of ₹78 cr. on March 31, 2017. Effectively, the suppliers are funding a lot of business operations of Caplin Point Laboratories Limited.”

How can trade payables be the cash/money should be getting from a supplier? I think you are telling the opposite. Instead, trade payables should be the cash owed by Caplin to the suppliers. Correct?

Could you clarify, please?

Author’s Response:

Hi,

Thanks for writing to us!

We look at it from the following perspective:

In scenario A, when suppliers demand upfront payment (e.g. Rs. 100 cr.) for sending goods to any company, then the company has to arrange Rs. 100 cr. and pay it upfront to suppliers, which means cash outflow of Rs. 100 cr. from the company, on the day it received goods from the supplier or even before receiving goods.

Whereas in scenario B, if the company is able to get a credit period from suppliers for e.g. 1 month, then the company needs to pay Rs. 100 cr. after 1 month from the date it received the goods from the supplier.

Scenario B is like a situation where the supplier has given an interest-free loan of Rs. 100 cr to the company for 1 month where it has agreed to get it payment after 1 month and the company is free to use the Rs. 100 cr. in any manner, it wants, which otherwise it would have had to pay to the supplier on day 1 (like in scenario A).

That’s why trade payables are effectively interest-free funding from suppliers to the company. The reverse is true for the trade receivables, which is similar to the company giving interest-free funds to its customer.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Working capital cycle, capacity expansion and utilization

Hi, I want to ask two very basic questions which I am stuck with since I have very little financial knowledge. They are:

1. How do you analyze the working capital cycle of a company?
2. How to analyze the capacity expansion and utilization from a company’s balance sheet?

Author’s Response:

Thanks for writing to me.

1) Working capital cycle is Inventory days + Receivables days – payables days. You may find the formulas about the calculation of these easily on google. You can calculate all these from the data in the balance sheet.

2) Total capacity and utilization are usually given in the annual report (esp. directors’ report or management discussion & analysis). You may find them sometimes in the credit rating reports as well. It may be mentioned by the equity research report of the company published by brokers who interact with management.

Also Read: Understanding Annual Report of a Company

Also Read: 7 Important Reasons Why Every Stock Investor should read Credit Rating Reports

Hope it helps!

Regards,

Dr Vijay Malik

Ratios: Year-end value of parameters or average value over the year

Dear sir,

First of all, thanks for your dedicated work on Indian stocks in fundamental analysis. Basically, I am a technical investor nowadays. I began to invest in good fundamental companies with some distance stop loss.

Your articles amazed me that the way you pick stocks and your conviction to hold the stocks even when it goes below buying price. This attracts me to work more on fundamental analysis.

Actually, I wanted to ask about this company in your Q&A Analysis. It’s my luck that you have already given your analysis of this company.

Now I working on the fundamental analysis based on the guidance given on your website. I took Metalyst Forgings Limited (erstwhile Ahmednagar Forgings Limited) for studying purpose.

Read: Analysis: Ahmednagar Forgings Limited

The calculation which I got for receivable days and inventory turnover was not matching with your calculation

I could not understand how to get these figures using screener data. Here are the figures I got from screener default excel sheet of this company. Please see the attached file.

So please guide me about how you derive these numbers from screener Data

Thank you!

Author’s Response:

Thanks for writing to me! I am happy that you are doing your own analysis and calculating all the ratios at your end before you take any final decision about the company.

The difference between the ratios calculated by you and me is due to the data assumptions:

You have taken inventory and receivables at the year-end values, whereas I have taken the average of values of inventory & receivables at the start and end of the year.

Financial analysis is a mix of science and art. Science is in calculation and art is in assumptions, interpretation & taking the decision.

In case, you believe that the year-end value is better to calculate the ratios, then you should use it and make the investment decision whether to buy or avoid or hold or sell.

Hope it clarifies your concerns!

Regards,

Dr Vijay Malik

Terms related to the inventory of a company

Hello,

Thank you for your reply.

Could you please explain what is mean by Purchase of Stock-in-Trade? As far as I know from the internet, the company produced more product then it sold. The company deducts the cost incurred in manufacturing the extra goods from the current year costs. The company will add this cost when they manage to sell these extra products sometime in future. This cost, which the company adds back later, will be included in the “Purchases of Stock in Trade” line item. Is it correct? In that case, the company will include the total product cost or only expenses?

Author’s Response:

Hi,

Thanks for writing to me! I am happy that you are spending time to understand accounting, which is the language of business. It is very essential to have a good understanding of the business of the companies, which an investor plans to analyse.

Your understanding is right. The cost related to the goods is recognized in P&L when these goods are sold. Otherwise, the cost is deducted from the cost of materials purchased in the year and is shown in the balance sheet under current assets/inventory.

Read: Understanding the Annual Report of a Company

All the best for your investing journey!

Regards,

Vijay

P.S.

• Subscribe to Dr Vijay Malik’s Recommended Stocks: Click here
• Mumbai “Peaceful Investing” Workshop, July 27, 2025: Register here
• To learn stock investing through videos, you may subscribe to the Peaceful Investing – Workshop Videos
• 25% savings on buying our Stock Analysis Excel Template and all ebooks together: Analysis Package: Excel Template + All eBooks (25% savings)
• To download our customized Stock Analysis Excel Template for analysing companies: Stock Analysis Excel
• Learn about our stock analysis approach in the e-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing”
• To learn how to do business analysis of companies: e-book: Business Analysis Guide
• To pre-register/express interest in a “Peaceful Investing” workshop in your city: Click here

Your Turn: 

I would like to know about your approach to 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.

You may like the blog’s Facebook Page, subscribe by email, follow the RSS feed or on Twitter so that you would immediately get to know when new articles are published on the website.

Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.