The current article in this series provides responses related to the following queries:
- When a company is better off by selling all its assets and invest the money in Bank’s fixed deposits?
- Applicability of (net PAT/total assets vs FD) to banking/financial institutions/service sector companies
- Use of PBT/NFA for estimating asset productivity
When a company is better off by selling all its assets and invest the money in Bank’s fixed deposits?
Hi Dr. Vijay,
I was one of the participants of your “Peaceful Investing” workshop in Delhi on May 13, 2018. I had a query while I was going through your ‘Peaceful investing’ e-book.
On page 100, we have a snippet of financials of ‘Atul Auto Ltd’. The sales growth looks good. Good profit growth in absolute numbers. However, my doubt comes from the fact that at the bottom line for the P&L, the business has only 6-8% NPM. Is this a good number to have for any business?
I understand that this is a capital-intensive business. However, at the end of the year, it is still generating only 6-8% for equity holders after repaying the debt, compared to 6-7% return from a fixed deposit. The free cash flows may be good, but shouldn’t the net profit be much better than that.
I think I may be missing something here. To understand it better, I will appreciate your help on this!
Regards,
Author’s Response:
Hi,
Thanks for writing to us! It was great to have you at the workshop!
We believe that comparing the net profit margin (NPM) with fixed deposit (FD) interest rate may not be a like-to-like comparison. Let us illustrate:
Let us assume if we invest ₹100/- in an FD and the interest rate is 7%. Then in one year, we will have interest income (pre-tax) of ₹ 7/-. We will pay about ₹2 as a tax (30%) and therefore, we will have ₹5 as income after tax.
In this example, the NPM is about 70%, which is after-tax income/Total income = 5/7
However, this case represents that the total assets put in the business/FD are ₹100, which provided after-tax net income of ₹5/-. So the total return on assets is 5% i.e. after-tax income/total assets = 5/100
Further advised reading: How to do Financial Analysis of Companies
If in case of companies, we find that the net profit after tax on total amount of assets is less than the net profit after tax earned by investing the same amount in FD, then we may arrive at the conclusion that it is not worthwhile to run the business.
Over time, while analysing companies for readers’ submissions, we have found that many companies are not able to earn a return on their total assets that are higher than fixed deposits. An investor may read some of the examples in the following articles:
- Analysis: Globus Spirits Ltd
- Analysis: Meghmani Organics Ltd
- Analysis: Castex Technologies Ltd / Amtek India Ltd
- Analysis: KNR Constructions Ltd: Some road assets are earning toll income, which is much less than the interest income that the company would have earned by putting the cost of building the road in a fixed deposit.
Therefore, to conclude, we believe that an investor may compare the cases, where if a company invests all its assets in FD, then what money it would have earned after tax. If that return from FD after tax is higher than the net profit after tax (PAT) from running the business, then it might mean that putting all the effort to run the business may not be worth it.
Hope it answers your queries.
All the best for your investing journey!
Regards,
Dr Vijay Malik
Follow up query:
Applicability of (net PAT/total assets vs FD) to banking/financial institutions/service sector companies
Sir, a follow up query about comparing (net PAT/assets employed) with fixed deposit (FD) returns. Is there any such way of comparing banking/finance stocks like this manner?
Most of these companies have return on assets of 1-2% and comparing with FD returns of 5% (after tax) I suppose can’t be done.
Regards,
Author’s response:
Hi,
Thanks for writing to us!
In case of financial institutions or other services companies, fixed assets are not the primary determinant of returns. This is because these companies have people oriented businesses. A company can increase its business by hiring more employees (bankers/software developers etc.) within the existing assets (buildings). The company may not need to invest in new physical assets each time it increases the number of employees to increase the business.
Therefore, in case of financial institutions and other services companies, the physical assets are not the primary factor influence the returns/profits. As a result, the parameter of net PAT/assets employed may not be highly relevant for such companies.
Hope it answers your queries.
All the best for your investing journey!
Regards
Dr. Vijay Malik
Use of PBT/NFA for estimating asset productivity
Dear Dr Malik,
In your analysis on Castex Technologies Ltd (erstwhile Amtek India Ltd), you have compared profit before tax (PBT)/net fixed assets (NFA) with fixed deposit (FD) rates. Is there any specific reason that you would prefer to compare PBT/NFA% with FD rates, instead of CFO/NFA% with FD rates?
CFO/NFA% for Castex Technologies Ltd comes to 12%, which is higher than the FD rate, & hence the question.
I understand, as you have mentioned elsewhere in many articles, that finance is versatile and it depends on individual investor preference. However, your reason would be helpful in the assessment.
Regards,
Author’s response:
Hi,
Thanks for writing to us!
Cash flow from operations (CFO) may contain the impact of business of previous years as well when receivables of last year are collected in this year. Similarly, CFO may not show the effect of full business done in the current year as many times receivables may be delayed to the next financial year.
Further advised reading: Understanding Cash Flow from Operations (CFO)
Therefore, to assess asset utilization, we prefer PBT/NFA.
All the best for your investing journey!
Regards
Dr Vijay Malik
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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.
