Operating efficiency Of a Company

How To Do Operating Analysis Of a Company.

As I had mentioned in my previous post on financial analysis, I will cover up important ratios which include the mix of Balance Sheet, P&L Statement, and Cash Flow Statement. If in case you have missed it Please read it  How To Do Financial Analysis Of a Company. 

Operating analysis is the measurement of operating efficiency of a  company. It determines how the company is using its asset to generate revenue, use of working capital management by the company and to check if the company is generating cash from its operation to fund its expansion.

Past Performance of the operating efficiency gives a good idea of the management quality and the business ability of the company.Let’s go through some of the important ratios which I go through before moving ahead in my analysis.

1) Asset Turnover Ratio (nfat)

Instead of Total Asset Turnover Ratio, I prefer Net Fixed Asset Turnover Ratio because it covers important asset like Plants and Machinery used in a Manufacturing Companies to generate revenue.

Fixed Asset Turnover ratio tells the rate at which a companies asset produces revenue for it. In short, it tells how the company is using its operational assets like plants and machinery to generate a revenue.

Fixed Asset Turnover Ratio = Sales/Average of Net fixed Asset  Of Current and Previous Year.

Let’s take an example of a Company Vinati Organics Ltd. In screener website, you can get the data of Net Fixed Asset under Balance Sheet section check out for Fixed Asset.

Operating performance of a company

If you want to take data from Annual Report. I am taking Annual Report 2017, go to Balance Sheet, Under Assets look at Fixed Assets which has tangible assets and note number 10 beside it.

operating analysis

 

operating analysis

Go to note, here we can see the different investment made in the current year and previous year. Grand Total represents amount invested in Net Fixed Asset which is similar to the numbers mentioned in Screener Website

For 2017, I will take the average of numbers for both year 2016 and 2017 which comes to Rs 428 Cr(382+474/2). Sales for the Year 2017 is 666. So Net Fixed Asset Turnover Ratio = 666/428 = 1.56 for year 2017.  It means for Rs 1 invested in Fixed Asset, the Company has generated a revenue of Rs 1.55. Higher than 1 means business is producing more cash and consuming less.

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Sales 146 190 232 323 447 553 696 772 631 666
Net Fixed Asset 41 45 80 111 144 290 304 327 382 474
NFAT 3.79 4.42 3.71 3.38 3.50 2.55 2.34 2.44 1.78 1.56

As you can see from the table, Vinati Organics Ltd, was able to maintain a good NFAT of above 1 in past 10 years. In FY 2010 and FY 2011 the NFAT has reduced in comparison with previous year it was because the company had gone into expansion phase which can be seen with an increase in Net Fixed Asset. Net Fixed Asset has increased every year from Rs 41 Cr in 2008 to Rs 474 Cr in 2017.

Points to remember while analyzing NFAT:

  • Look in past if a company has maintained stable and increasing NFAT. Preferably above 1.It simply means a company is producing more cash than consuming it.
  • If NFAT is decreasing in some of the years, find out if the company is getting into an expansion phase. As it takes some years for newly installed machines to function properly and increase the NFAT of the company.
  • If NFAT is increasing or stable, the D/E ratio of the company should be less or decreasing. D/E ratio of Vinati Organics Ltd for past 10 years was always under check.
Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
D/E Ratio 0.8 0.8 0.6 0.5 0.9 1.0 0.5 0.2 0.1 0.0
2) Working Capital Management

A Company needs cash or we call it liquidity to perform its day to day operation. This term is called as a working capital management.Working Capital Management tells where the money is stuck which has resulted in a liquidity crunch for a company.  It can be determined by two most important parameters.

a) Inventory Turnover Ratio (ITR)

It measures the rate at which a company uses its inventory i.e raw material, work in progress and finished goods to convert it into sales. It is good to have increasing or stable ITR.

Higher ITR means that a company is able to convert its inventory into sales and its capital is not stuck in inventory. Deteriorating ITR should be a big no as it means that the company’s money is stuck in inventory and company might take a working capital loan from a bank.

Inventory Turnover Ratio =  Sales / Average Inventory from Current and Previous Year

Operating Analysis

In Screener.in, you can get a complete data of past years in Balance Sheet Section Under Other Assets.

In an Annual report,  Inventories is given in Balance Seet under Current Asset Section.

ITR For Vinati Organics Ltd:

Year  2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Inventory Turnover ratio 12 16 15 12 11 11 14 15 13 12

As you can see Vinati Organics Ltd was able to maintain a good ITR ratio with a low in past few years. An investor should find out the reason for such a decrease in ITR before putting his hard earned money in any company.

b) Receivables Days

Company issues product on credit. It means customer buys a product and pays later. It’s a duty of the company to collect the money from its customer.

Receivables Days determines the average numbers of days in which customer pays the money back to the company. Lower the number better is the operating efficiency of the company.

Receivables Days = 365/(Sales/Average Receivables from Current and Previous Year)

In Screener.in, you can get a complete data of past years in Balance Sheet Section Under Other Assets.

In an Annual report,  Receivables is given in Balance Seet under Current Asset Section, just below inventories.

Receivables Days of Vinati Organics Ltd:

Year  2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Receivables Days 61 48 50 50 56 66 60 58 71 70

In case of Vinati Organics Limited, the receivables days has been maintained at around 2 months in past 10 years. It’s good on its part of collecting money from its customers.

Ideally, its good to invest in a company which has stable or decreasing receivables. Increasing receivables days means that the cash is stuck in receivables and company might take working capital fund from a bank and it may result in increasing interest payment and a decrease in net profit of a company.

3. sources of fund

It’s important to look for a company which does not fund its operation with the help of debt. A company which uses cash flow from operation after doing capital expenditures is great to invest in.

An investor should avoid a company which has a high debt or is increasing its debt every year.Look for a company which generates free cash flow

Conclusion:

Now let’s see what we need to look at a complete financial level which includes both financial and operating analysis in a company before going into next step in investing.

1) Sales Growth > 14% for past 7 to 10 years.

2) Stable and Improving OPM and NPM in the past years.

3) D/E < 1

4) CFO > PAT

5) Stable or Improving Operating Efficiency

  • Net Fixed Asset Turnover(NFAT)- Higher the Better
  • Inventory Turnover Ratio(ITR) – Higher the Better
  • Receivables Days – Lower the Better

6) Sources Of Fund – If it’s from Free Cash Flow Its Better. Avoid High Debt Company.

 

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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