Financial analysis of a company deals with the quantitative checks about the companies financial health. In order to analyze companies financially, one mus read companies financial reports.
While practicing value investing, it is essential that the investor must know how to read and interpret balance sheets, profit loss accounts, and cash flow statements.
To practice value investing successfully it is essential that the financial condition of the company must be analyzed very thoroughly.
How one can analyze financial condition of a company?
It can be done by suitably applying financial ratios. The financial ratios use the numbers published in the companies financial reports.
Objective of calculating the financial ratios is to understand what is the financial strength of the company, and what are the potential risks associated with it.
Financial analysis using financial reports
So let’s look at the company’s balance sheet first.
In the balance sheet it is essential to check the DEBT levels of the company first. The idea is to understand how prepared is the company to handle its debt repayments when its due.
In the balance sheet, one can also find an information about how well the company is managing its short term Assets and short term liabilities.
This is a very important consideration that investors must review about the company.
Answer to this critical question (short term asset and liability management) can be obtained from two finance financial ratios : Current ratio & Quick ratio
#1. Current ratio
Current ratio is equal to current asset divided by current liabilities.
Current asset means cash, inventory, account receivables and prepaid expenses (advance).
Current liability means payment to the vendors against their invoices received by the company etc.
Benjamin Graham used to like current ratio a lot.
According to Benjamin Graham, current ratio of a company must more than 2. Company which has a current ratio of two or more means that the financial strength of the company is high.
But in today’s scenario, any company which is having a current ratio between 1 and 2 is acceptable.
If current ratio of a company is below 1, it means that the company will have sufficient cash to manage its current liabilities.
In other words, the company has liquidity problems. A company which is does not have sufficient liquid cash is in trouble.
#2. Quick ratio
Quick ratio is a more stringent quantitative check about companies liquidity strength.
Ratio is calculated by dividing cash Plus account receivables by current liability. Another way of calculating quick ratio is as shown in below formula.
Current asset minus inventory is almost like a hard cash available with the company. Current asset minus inventory mainly comprises of cash plus account receivables.
Company which has sufficient cash and account receivables is more likely to clear of its current liabilities without any problems.
Quick ratio of 1 signifies that the company is very well placed financially.
#3. Debt equity ratio
The debt equity ratio highlight that how much company is dependent on debt as compared to its equity base to fund its operations.
Company which Relies too much on debt is not good for the shareholders.
A good way of comparing debt levels of different companies is by formulating debt equity ratio’s for each company.
A company which has zero debt will have a debt equity ratio of zero. Value investors like debt free Companies.
But not all good companies can survive with zero debt. Hence the resort to debt, but to limited extent.
A company which has a debt equity ratio of 1 or below can be termed as financially strong.
There are companies which operates at a very high profitability margins.
If such companies can get cheaper loans, they can leverage this debt to increase their production capacity. Thereby making high net profits per share.
These are such companies which actually benefit from debt. Hence, all companies with debt load are not bad.
Investors must check debt equity ratio (<1) and profitability margins of companies before concluding. If margins of company is more then its cost of debt, it means that the company is leveraging debt very well.
#4. Interest coverage ratio
Interest coverage ratio is a more realistically evaluated financial ratio to understand if the company is a resorting to too much debt to run its business.
Interest coverage ratio is calculated by dividing EBIT (Net Profit+Interest+Tax) by interest expense.
The larger is the interest coverage ratio the better.
As a rule of thumb interest coverage ratio of 2 or more is considered acceptable.
When interest coverage ratio is high, it indicates that the company is well placed to pay the interest on its debt.
High interest coverage companies is more likely to continue paying interest even if their sales or profits falls.
Investors must fist check the debt equity ratio. This must be below one. Then they must also check if the interest coverage is high enough or not (>2).
High interest coverage ratio confirms that debt is being used well to generate high profits.
#5. Inventory turnover ratio
Inventory turnover is one of the financial ratios that can be used to highlight managerial efficiency.
Inventory turnover ratio is calculation by dividing cost of goods sold by average inventory maintained for the said period.
Inventory lying idle in companies warehouse is a cost to the company. Good managers would like to have as minimum inventory as possible.
Hence it takes a lot of good managerial skills to convert an idling inventory into a sale.
There are no thumb rules to measure an ideal inventory turnover ratio. However, what an investor can do here is to compare the company’s inventory turnover ratio with its nearest competitors.
This will given an idea to the investor that if the companies top managers were able to sell their inventory fast enough or not.
Here the investor is drawing conclusion by comparing companies performance with the standards of the SECTOR in which the company operates.
A company which has the highest turnover ratio must be preferred over its competitors.
#6. Receivable turnover ratio
Low receivable turnover ratio is a very big sign of efficient management.
Receivable turnover ratio is measured by cash received from customers divided by average receivable due for the said period.
Suppose there is a company whose average receivable in last 12 months was $100,000/month. The company collected $300,000 in a span of last 12 months. It means its receivable turnover ratio is 3 ($300,000 / $100,000).
What does this 3 means? It means that the company was able to collect the average payment of $100,000 thrice is a year.
In other words, the company is collecting money from customers every 4 months.
When 365 days is dividend by this ratio (365 / 3 = 121 days = 4 months), it shows the average number of days companies bill lay outstanding at the customers end.
The lower is the number of days the better.
But here again there is no thumb rule of an ideal receivable turnover ratio.
Ideally an investor should compare the receivable turnover ratio of the company in consideration with its competitors.
#7. Net profit margin (PAT margin)
PAT margin is a measure to understand how efficient is the business of a company.
Net profit margin is measured by dividing net profit of a company by the total sales.
Low profit margin of a company indicates to an investor that its business is not very price sensitive.
High profit margin means, even if the company has increases its selling price, its sale volumes are not going to be hampered much.
#8. Return on equity (ROE)
ROE is perhaps the most important metric which investors can use to judge if the company is profitable enough or not.
Equity is measured by net income divided by the book value (net worth) of the company.
In many ways than one, return on equity is one of the most desirable financial ratio that any stock investor must follow very closely.
Return on equity talks about the net income that a company generates for every dollar of shareholders fund.
Suppose there is a company to generate income of $2 for every dollar of shareholders fund. Suppose there is another company which generates income of $3 for every dollar of shareholders fund.
Which company is better for investing?
Of course the company which is generating higher income for every dollar of shareholders fund is most lucrative.
The real depth of ROE can be seen when the ROE formula is broken down as shown below.
A single formula talks about companies profitability, effectiveness of its assets and equity leveraging power.
#9. Return on Capital Employed (RoCE)
After ROE, RoCE is perhaps one of the most important ratio that defines if the company is using its funds in a profitable way or not.
To measure return on capital employed, one must divide net income by total employed capital for the business.
What is total capital employed? It is total equity plus total debt.
A company which is generating more net income for every dollar of employed capital is more lucrative for investment.
For value investors the lower is the debt. level the better.
So for a company which has zero debt will have return on equity equal to return on capital employed.
Such companies are loved by Value investors.
#10. Return in asset (ROA)
ROA is perhaps the toughest measured by which the performance of a company can be evaluated.
To Calculate return on asset net income of company is divided by total assets.
To calculate return on capital employed, all resources that a company can utilize to generate income is taken into consideration (equity + total debt).
Equity + total debt = Total liability
Companies balance sheet, always the total liability = total asset.
We can say that, return on asset is also equal to return on capital employed.
When a company accumulates capital in the form of equity or debt they use this fund to build assets. Has it can be current asset or a fixed asset.
These assets intern generate income for the company.
To understand return on asset in one way we can say that a company which generates more income with less employed asset is more profitable.
Other words we can also say that a company which generates more income with was employed capital is more profitable.
Return on capital employed and return on asset is one and the same thing.
Value investors it is also important to check the quality of income of Companies.
#11. Quality of income
This can be formulated by comparing profit and loss statement with the cash flow data.
Quality of income is equal to cash flow from operating activity divided by the operating income.
Flow from operating activities is available in companies cash flow statement.
Operating income is available in companies profit and loss account.
#12. Capital Expenditure
Value investors also keep a very careful watch on the company in consideration that whether they are making sufficient capital expenditure or not.
This they do by comparing the depreciation expense of a company with its annual capital expenditure.
Assets of companies depreciate with time. Hence companies need to expand and modernized its facilities to maintain the competitive advantage.
A company which is not spending sufficiently to build new assets or to modernize their existing facilities, will eventually lose their competitive edge.
All a company should spend on capital expenditure at least equal to its annual depreciation figure.
For value investors, it is important that they do not rely only on one year data of a company.
The person should look at at least on the last 5 years data to understand a pattern of the company’s financial strength and weaknesses.
I personally use last 10 year data of company to understand if they are good for investing or not.
Getting 10 year data about a company is not so difficult these days. Websites like moneycontrol.com provides all historical financial data about the company.
Analyzing company based on such large database establishes more accurate assumptions.
Only if one analyzes last 5-10 years financial data of the company, conclusion can be made that whether the company will with will remain to be financially strong/weak in long term or not.
Conclusions about the company based on its short term performances is not reliable.
Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyze all securities before investing in one.