How To Do Financial Analysis Of A Company.

Financial analysis is the first step to look at while doing in-depth research on any company. The financial analysis consists of a study of some ratios and growth rate. It is very easy to understand and anyone can learn from it.

Financial Analysis is a combined study of ratios from Balance Sheet, Profit & Loss Statement, and Cash Flow Statement. We need to go through different ratios in each of the statements before going ahead with our analysis.

Balance Sheet, Profit & Loss Statement, and Cash Flow Statement are the important financial section in the Annual report which should be studied in detail. These statements tell the story in numbers which will help investors to know the financial health of the company.

In short, “Financial Analysis is a detailed study of what the company earns in a form of its sales, its expenses, operating profit, what are the taxes paid by the company, what is the net profit, how much is the dividend distributed to the shareholders and how much debt the company has taken to buy its asset and how much debt it has under its belt”.

Financial analysis should not be done for a particular year instead it should be done over a long period of time. The trend of different ratios and growth rate should be seen for 10 years as it will cover up one complete economic cycle.

Let’s try and understand the financial analysis of a company with an example.

Now with the use of the internet, we can easily get all financial data. With the help of Screener.in, you can export financial data in Microsoft Excel File.Here, there is no need to calculate each and every ratio as it is readily available.

Here I am using an example of a company Ambika Cotton Mills Limited.

 

1. P&L statement analysis

P&L Statement includes the income generated by the company in form of sales followed by expenses done to generate the sales and ends up with a net profit of the company.

a) Sales Growth:

The first parameter to look for in financial analysis is the sales growth the company has achieved in the past. It is very important as it shows whether the product or services produced by the company is in demand or not.

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 CAGR
Sales (In Cr. ) 156 178 208 319 389 398 477 495 492 529 14.5%

 

As you can see from the table above, sales of Ambika Cotton Mills Limited has increased from 156 Cr to 529 Cr from 2008 to 2017 giving a CAGR of around 15% on year to year basis.

One or two year of sales growth less than the previous year is fine, but more than that is a big no for me.In case of Ambika Cotton Mills Limited, Sales in the Year 2016 was less than the Year 2015.

In my last post, I had mentioned that I look for a company whose sales growth for past 10 years is around 14%. The main reason for keeping minimum 14% sales growth is because India’s Nominal GDP which is Real GDP Growth Rate + Inflation Rate is growing around  14.7% in past 10 Years.

Real GDP growth rate = 7%(Past 10 years)

Inflation Rate = 7.7%(Past 10 years)

An investor can set minimum growth rate for sales as per his wish. High Sales growth rate such as 50% is highly unsustainable and should be avoided by the investor.

b) Profit Margins

Operating Profit Margin and Net profit Margin are the two important parameters to check the profitability of the company.

OPM is the money left after paying the operating expense. Operating Expense is the material cost to make a product of the company, manufacturing cost, employee cost and any other cost like fuel and power.

Operating Profit does not include expense like depreciation of the fixed asset, interest expense for the loan taken and the taxes which company pays.

OPM = Operating Profit/ Sales

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
OPM 25% 23% 22% 31% 20% 22% 22% 20% 19% 20%

In case of Ambika Cotton Mills Limited, the company was able to maintain an OPM of around 22% in the past 10 years. Increasing or a stable OPM is a good sign as it shows that the company has a control over its operating cost.

Net Profit is the final money left with the company after paying all the expenses such as depreciation, interest expense, and taxes. The money can be used by the company to either reinvest in the company for its expansion or it can share the fruits with its shareholders in a form of dividends.

NPM = Net Profit/Sales

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
NPM 8% 5% 9% 13% 6% 8% 10% 10% 9% 11%

Ambika Cotton Mills Limited has been able to maintain a good NPM around 10% in last 10 years.

An Investor should look for a company which is able to maintain or increase its profitability because such company is able to face tough times and makes money for its shareholders.

c) Tax Rate

Paying regular tax rate is a good sign of a corporate governance and accounting standards of the company. In India, the corporate tax rate is around 30%. We should look for a company which pays regular taxes.

There are various Tax incentives provided by different states in India. Certain Sectors also enjoys tax benefits which reduce its tax payout and ultimately increases net profit of the company. Very low tax payout should raise a red flag and should be analyzed further.

      Tax Rate = Tax /Profit Before Tax

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Tax Rate 30% 28% 22% 29% 26% 24% 19% 20% 25% 23%

We can see that Ambika Cotton Mills Limited has not paid taxes which is around 30% in India. The company enjoys tax benefits as it is in the Textile Industry which has resulted in paying less tax. An investor should check whether the company is enjoying any tax benefits before giving its final conclusion.

d) Interest Coverage Ratio

It is a measure to check whether an operating profit generated by the company is sufficient enough to pay the interest amount to its lender. Look for a company whose Interest Coverage Ratio is more than 2.

Interest Coverage Ratio = Operating Profit/Interest expense

If the Company is Having Interest Coverage Ratio of Rs 4, it simply means for that for Rs 1 of Interest expense, Company is able to make an operating profit of Rs 4.

Higher Interest Coverage Ratio provides a great safety during bad economic condition.

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Interest Coverage 1.3 1.6 3.3 3.2 5.9 8.9 10.2 18.8 26.25

Ambika Cotton Mills Ltd has an interest coverage of about 64 which will provide a great safety for an investor in tough times. Such a high-interest coverage simply means that company is having a negligible debt under its book.

2. Balance sheet statement analysis

Balance Sheet provides the information about the asset and the liabilities held by the company in a given particular year.Assets are machinery and plants which are going to generate sales for the company while liabilities are the sources of fund required to buy these assets.

a) Debt/Equity Ratio (D/E)

A company buys assets which are used to generate revenue for it. For manufacturing companies, plants and machinery are the assets which will generate sales.

To buy these assets, it needs money. As these assets are very expensive, the owner of the company cannot afford it. So where will the money come from?????Either the company will go to the public in form of share holder’s fund or take a loan from the bank in a form of debt.

Liability-Side of a Balance Sheet specifies sources of fund i.e from where the company has got money to buy assets. Liability Consists of two-part 1) Share Holders Fund 2) Debt.

Share-Holders Fund = Share Capital + Reserves, while Debt = Long-Term Borrowings + Short-Term Borrowings.

Debt/Equity Ratio measures how much funds have come from debt in a form of a loan or from its own company in a form of shareholders equity. If D/E ratio is 1, it means 50% of the fund is borrowed from lenders and 50% from shareholders equity.

D/E = Total Debt/Total Shareholder’s Fund

I like companies having low D/E ratio. Preferably less than 1 and which is decreasing every year. During bad times, if a company is not making money, lenders will ask to return back their money. In such scenario, it will sell off its asset to return the money and leaving nothing for the shareholders.

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Share Capital (a) 5.88 5.88 5.88 5.88 5.88 5.88 5.88 5.88 5.88 5.73
Reserves (b) 105 115 130 169 190 214 254 295 329 369
Total Shareholders Fund (x=a+b) 111 121 136 175 196 220 260 301 335 375
Long-Term Borrowings (c) 279 251 222 260 152 94 100 63 20 7
Short-Term Borrowings (d) 0 0 0 11 0 0 0 0 0 0
Total Debt (y=c+d) 279 251 222 260 152 94 100 63 20 7
D/E (y/x) 2.5  2.1 1.7  1.5  0.8 0.4   0.4 0.2  0.1  0.0 

Ambika Cotton Mills Ltd has consistently reduced its debt and in 2017 it had a D/E ratio of 0 which is a great result and shows good business handling ability of the management.It simply means that Ambika cotton mills ltd does not owe anything to anyone and it depends on its internal resources to buy assets.

b) Current Ratio (CR):

Current Ratio is a ratio of current assets and the current liabilities of the company.

Current Assets are the assets which are going to be utilized in a next one year. It consists of inventory that gets converted into finished goods which are to be sold in next one year, money due from the customers (account receivables) and cash-like investments which are used for day to day operations in the company.

Current Liabilities are the liabilities which has to be paid in next one year in a form of trade payables and short-term provision.

If Current Asset is greater than Current Liabilities it simply means that CR>1 and company will be able to pay its short-term loan with the help of money to be received from the current asset.

Current Ratio = Current Asset/Current Liabilities.

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Inventories (a) 108 109 137 150 83 92 133 144 124 151
Trade Receivables (b) 4 7 23 21 10 6 6 6 18 41
Cash (c) 13 2 5 3 2 1 3 3 5 13
Current Asset (x = a+b+c) 125 118 165 174 95 99 142 153 147 205
Trade Payables (d) 31 28 53 43 34 49 33 23 19 45
Provision (e) 3 3 4 4 18 15 21 23 12 17
Current Liabilities (y = d+e) 34 33 57 47 52 64 54 46 31 62
Current Ratio (x/y) 3.67 3.57 2.89 3.70 1.8 1.54 2.62 3.32 4.74 3.3

Looking at the table, Ambika Cotton Mills Limited is having CR ratio in excess of 1 in all 10 years. I prefer CR> 1.

3. Cash flow statement analysis

This section gives a detail movement of cash being used by the company during the year. It includes three parts 1) Cash flow from Operation (CFO) 2) Cash flow from Investing (CFI) 3) Cash flow from Financing (CFF).

  1. Cash flow from Operation (CFO): This section gives detailed information about cash received by doing core operation of the business in the financial year.
  2. Cash flow from Investing (CFI): This section gives detailed information about cash used to buy assets or cash received by selling assets in the financial year.
  3. Cash flow from Financing (CFF):  This section gives a detailed information about cash raised by borrowing taken from financial institutes and repaid during the year.

An investor should look for a company which generates a great amount of cash flow from operation. Look for a company whose CFO can take care of CFI and CFF.

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Cash Flow From Operations (CFO) +40 +51 +39 +73 +135 +87 +38 +43 +67 +68
Cash Flow From Investing (CFI) -93 -15 -1 -82 -4 -9 -28 -9 -13 -28
Cash Flow Fron Financing (CFF) +60 -47 -34 +7 -132 -80 -8 -33 -52 -32
Net Cash at end of the Year. 7 -11  3 -3  -1  -2   2 8

The (-) sign indicates that the cash has flowed out of the company. If CFO is (-) the company has generated nothing from its core operation, if CFI is (-) it means to buy an asset the company has used cash, and if CFF is (-) the company is repaying its loan

The (+) sign indicates that the cash has flowed inside the company.  If CFO is (+) it means it has received cash by doing core operation of the business, if CFI is (+) it means that the company has sold its asset because of which it has received cash, and if CFF is (+) the company has received a loan from the bank.

Net Cash = CFO + CFO + CFF. Net Cash is the cash left with the company after doing all the three operations

In case of Ambika Cotton Mills Ltd, it has generated a healthy amount of CFO. Its CFO has increased from Rs 40 Cr in 2008 to Rs 68 Cr in 2017. It has funded its CFI with the mix of CFO and CFF. In 2017, it generated Rs 68 Cr from CFO, out of which 28 Cr, it invested in buying assets and Rs 32 Cr it paid back in a loan.

Net Profit  vs CFO

A company that sells products or provides services may not receive its payment immediately. However, accounting standards may allow it to report its sales and net profit in P& L Statement. But the cash received from the customers will be reflected in Cash Flow Statement.

For example, suppose the company is selling a pen. It sells a pen to a particular customer and he tells a company that he will pay on the later date. As per accounting standards company can make an entry of a sales in P&L Statement even though it has not received cash. Its a duty of the company to collect the money from the customers. This money received is actual cash which always gets reflected in Cash Flow Statement.

We should check PAT and CFO over a long period of time. If CFO=PAT or CFO>PAT, it means the company is able to collect cash from the customers and if PAT > CFO, it simply means that company is unable to collect the cash and the profit mentioned is not true.

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Total
CFO 40 51 39 73 135 87 38 43 67 69 642
PAT 13 9 19 42 24 31 48 51 44 56 338

 

In case of Ambika Cotton Mills Ltd, the company has managed to generate CFO of Rs 642 Cr in comparison with the PAT of Rs 338 Cr over 10 years period of time, which means that company has managed to collect cash from its customers.

Final checklist

Sales Growth > 14% for past 7 to 10 Years

OPM & NPM: It should be high and sustainable. NPM > 9% is good.

Tax Rate: It should be more than 30%. If it is less check the reason behind it.

Interest Coverage Ratio > 2

D/E < 1

CR > 1

CFO>0

CFO>PAT or CFO = PAT

In next post, we will deal with the ratios used in the mix of Balance Sheet, P&L, and Cash Flow Statement.It will measure the operating efficiency of the company.

Hope you have understood the concepts mentioned in the above post.

Happy investing!!!!!

About the author

Yash Birajdar

Hey I'm Yash Birajdar, an Engineer, Pistol Shooter and a Value Investor. I am here to learn and help readers with knowledge related to Value Investing In Stock Market in simple way.

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6 Comments

  • Hi Yash,

    How did you arrive at the Interest Coverage Ratio.
    As i have taken your example- Interest Coverage Ratio = Operating Profit/Interest expense
    Example: Mar 2017: OP – 104,93/ interest 4,43 = 23,69
    And you mentioned 64.3

    • Hey Dhanpal,
      I am glad that you are trying it on your own and learning. I am sorry it was my mistake. I have corrected it. You can check it.

    • Hey Ajay,
      I hope my website is helping you to understand about stock market. Yes the data is readily available. You can get the data from annual report of the company or you can get the data from screener.in. I will soon write a article on how to calculate it with a live example. Till then stay tuned with new articles.

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