Value Investing & Financial Analysis

Financial analysis of a company deals with quantitative checks on the company.

Why to do these quantitative checks?

This is done to evaluate the companies financial health.

How quantitative checks are done?

By reading the companies financial reports.

Before one buy any stocks, it is essential to double-check by self, the financial condition of the company.

How one can do this?

  • Step 1: Access the company’s financial report.
  • Step 2: Use financial ratios to comprehend the numbers.

Financial ratios use the numbers published in the companies financial reports.

This is done for the following 2 reasons:

  1. To judge the financial strength of the company, and
  2. To know what are the potential risks associated with the company.

Basically there are 3 type of financial reports published by companies each year:

  1. Balance Sheet.
  2. Profit & Loss A/c.
  3. Cash Flow Statement.

Each type of financial report can be used, sometime in combination, to analyse the company’s business fundamentals.

There are two ways to do this analysis:

Value investing cannot be said to be complete without estimation of “intrinsic value”.

But it is a fact that not everyone can do this math.

Hence the best compromise is the “use of financial ratios”.

Lets see few financial ratios which can be used check business fundamentals of companies.

#1. Financial Analysis using Balance Sheet.

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.

Why debt analysis first?

Because a good debt can enhance shareholders returns, and a bad debt can do otherwise.

Debt analysis is done to ensure how prepared is the company to handle its debt repayments when its due.

Short term Assets and short term liabilities also needs proper management.

Financial ratios (like Current Ratio and Quick Ratio) can help us to check this as well.

#1.1. Current ratio

Financial Analysis -1

It is a ratio between current asset and current liabilities.

Current asset can be: cash, inventory, account receivables and prepaid expenses (advance).

Current liability can be: invoice payments to vendors etc.

Benjamin Graham used to like current ratio a lot.

According to Benjamin Graham, current ratio of a company must be more than 2.

Current ratio of more than 2 is one of the important indicators of strong “financial health“.

But in todays scenarios, this is a tough ask.

Hence having a current ratio between 1.2 and 2 is also acceptable.

If current ratio is below 1.2, means available may not be sufficient to manage current liabilities.

In other words, the company has liquidity problems.

A company which has a prolonged liquid cash is in trouble.

#1.2. Quick ratio

Financial Analysis -2

Quick ratio is a more stringent quantitative check on companies liquidity strength.

Normally, total current assed means summation of the following three:

  1. Cash,
  2. Account receivables &

But to calculate  quick ratio, only cash and account receivable is picked.

Quick ratio formula can be represented as shown below:

Current asset minus inventory is almost like “hard cash” available with the company.

What is hard cash? Cash plus account receivable.

This ratio gives a very realistic representation of companies ability to pay the dues.

Quick ratio of more than 1 is one of the important indicators of strong “financial health“.

#1.3. Debt equity ratio

Financial Analysis -3

It highlight how much company is dependent on debt to fund its operations.

This understanding is achieved by comparing company’s debt with its equity.

The formula for debt-equity ratio is as shown below:

Company which relies too much on debt, increase the risk for its shareholders.

Use of this ratio is a fair way of comparing apple to apple.

All companies has different debt levels.

It does not necessarily mean that, a company carrying Rs.100 crore is bad than a company carrying Rs.15 crore in debt.

Debt Equity ratio helps to rationalise this kind of disparity.

Which debt equity ratio is best? There are no set rules, the lower the better.

Hence, value investors like debt free Companies (debt equity ratio of zero).

But not all good companies can survive with zero debt. Hence the resort to debt, but to limited extent.

Debt-Equity ratio of less than 1 is one of the important indicators of strong “financial health“.

[Suggested further reading: Debt is good or bad for companies]

From this point onwards we will also include numbers from Profit & Loss account.

#1.4. Interest coverage ratio

Financial Analysis -4

It again highlights the debt dependency of the company.

Interest coverage is a ratio of EBIT (Net Profit+Interest+Tax) and interest.

The formula is as shown below:

The bigger is the coverage ratio the better.

What means by high interest coverage ratio?

It indicates that the company is well placed to pay the interest expense.

Companies having high interest coverage ratio is poses less risk for its shareholders.

Such companies are likely to continue paying interest even if their sales or profits falls.

Interest coverage ratio of more than 2.5 is one of the important indicators of strong “financial health“.

There is a small rule that can be followed to check debt levels:

  • Fist, check the debt equity ratio. This must be below one.
  • Secondly, check the interest coverage. It must be above 2.5.

#1.5. Inventory turnover ratio

Financial Analysis -5

This is a financial ratios that can be used to highlight managerial efficiency.

It is a ratio between “cost of goods sold” and “average inventory maintained” for a said period.

The formula is as shown below:

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 is to compare the company’s inventory turnover ratio with its nearest competitors.

This will given an idea of whether the inventory is selling fast enough.

High inventory turnover ratio (comparatively) is one of the important indicators of strong “financial health“.

#1.6. Receivable turnover ratio

Financial Analysis -6

Low receivable turnover ratio is a very big sign of efficient management.

Receivable turnover ratio is a ratio between cash received from customers and average receivable due for the said period.

The formula is as shown below:

Lets consider an example:

  • Average receivable of a company: $100,000/month (in last 12 months).
  • Collection done: $300,000 (in last 12 months).

What will be the receivable turnover ratio of this company?

Its receivable turnover ratio is 3 ($300,000 / $100,000).

What does this 3 means?

It can be comprehended in two ways:

  1. The company collected an average payment of $100,000 thrice is a year.
  2. The company is collecting money from customers every 4 months.
  3. The company’s bills remain outstanding for 121 days (approx. 4 months).

How to calculate “days outstanding”?

Dividend 365 by this ratio to get number of days

= (365 / 3 = 121 days = 4 months).

The lower is the number of days the better.

One must compare the receivable turnover ratio of the company in consideration with its competitors.

High receivable turnover ratio (comparatively) is one of the important indicators of strong “financial health“.

#1.7. Net profit margin (PAT margin)

PAT margin is a measure to understand how efficient is the business of a company.

Net profit margin is a ratio between net profit and total sales.

Probably this is one of the most utilised financial ratio of all.

High profit margin of a company hints at competitive advantage enjoyed by the company.

Such companies will enjoy their market dominance even if they increase their selling price.

Such companies tend to hold the market share better as they are monopoly business.

#1.8. Return on equity (ROE)

Financial Analysis -7

ROE is perhaps the most important stocks metric for investors.

It can be used to judge about the company’s profitability.

ROE is a ratio between net income and book value (net worth).

The formula is as shown below:

Return on equity (ROE) is that financial ratio that must be followed closely. Why?

ROE talks about the capability of the company to generate net profit for every dollar of shareholders fund.

Example:

  • Company-A generates net profit of $2 million.
  • Company-B generates net profit of $3 million.

As an investor, looking only at the absolute profit values, which company looks more inviting?

Company-B, as it is generating higher profits.

But let dig slightly deeper.

Company-A has a Net worth of $15 million. Company-B has a Net worth of $24 million.

What will be the ROE for both?

  • Company-A, ROE of 13.33% (2/15).
  • Company-B, ROE of 12.50% (3/24).

From point of view of a shareholder, Company-A is more profitable.

It is generating higher income for every dollar of shareholders fund is most lucrative.

1.8.1 Why is not like any other financial ratio?

The real depth of ROE can be seen when the ROE formula is broken down as shown below.

A single ROE formula talks about the following:

  • Profitability,
  • Effectiveness of its asset, and
  • Equity leveraging power.

Financial Analysis -7-1

#1.9. Return on Capital Employed (RoCE)

After ROE, RoCE is my favourite financial ratio.

These two ratios speaks a lot about the companies companies profitability.

RoCE is a ratio between EBIT and total employed capital.

The formula is as shown below:

What is total capital employed?

It is the total funds used by the company to run its operations.

Employed Capital = (Share Capital + Reserves) + Total Debt.

= (Net worth) + Total Debt

A company which is generating higher operating profit for every dollar of employed capital,  is more lucrative for investment.

Financial Analysis -8

#1.10. Quality of income

This can be formulated by comparing “profit and loss statement” with the “cash flow data”.

Quality of income highlights, what proportion of EBIT gets converted in “actual hard cash” received by the company.

Quality of income is a ratio between “cash flow from operating activity” and “EBIT”.

The formula is as shown below:

Quality of income = Cash flow from operating activity / EBIT.

The higher is the ratio the better.

Note:

  • Cash Flow from operating activities is available in companies cash flow statement.
  • EBIT is available in companies profit and loss account.

#1.11. Capital Expenditure

Value investors also keeps a check on company’s capital expenditures.

How to do this check?

Comparing the “depreciation expense” with its “annual capital expenditure”.

Why to do like this?

Assets of companies depreciate with time.

Hence companies need to expand and modernise their facilities to maintain the competitive advantage.

A company which is not spending sufficiently on expansion and modernisation, will eventually lose their competitive edge.

All a company should spend on capital expenditure at least equal to its annual depreciation figure.

Final Words…

For value investors, it is important that they do not rely only on one year data.

Looking at least on last years 5 data is necessary.

This helps to understand a pattern of the company’s financial strength and weaknesses.

Expert investors often use last 10 year data for analysis.

Getting 10 year data about a company is not so difficult these days.

Websites like moneycontrol provides all historical financial data about the company.

Analysing company based on such large database establishes more accurate assumptions.

Conclusions about the company based on its short term performances is not reliable.

Back: Value Investing & Circle of Competence

Next: Stock Valuation by Reproduction Cost Method

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