8 Steps to Financial Analysis of any Company

“What financial Analysis aims to Analyze?”

 Amount of income the company earns in Sales

 Amount of profits it is able to retain for Shareholders
 Sources of funds which a company has used for creating its Assets
 Amount of cash it generates from its Operations and utilization of this Cash whether for
Investments and Debt Repayment.
 Aim is to find companies which have a healthy financial position that can offer the potential
for Future Growth.

“Steps of Financial Analysis”

For Financial Analysis you need to analyse the Financial Statements

 Balance Sheet
 Profit & Loss
 Cash Flow

Entire Financial Analysis consists of study of only two things:

 Ratios
 Growth Rate

“How to get Financial Data of Companies in seconds”

https://www.screener.in

Analyzing a Company

“How to read an Annual Report”

https://www.youtube.com/watch?v=voeHHdrph7A&t=33s

 Infosys has one of the best Annual Reports.

 Annual Reports to be read over the years in order to get hold of the company.

“Analysis of P&L: Sales Growth”

(₹ Jun- Jun- Jun- Jun- Jun- Mar- Mar- Mar- Mar- Mar- CAGR
Crores/1 11 12 13 14 15 16 17 18 19 20 FY
0 Million) 2011-
2020
Sales 2469 2928 3404 3961 4254 2960 4462 4969 5612 5511 ~9%

 The first thing to check is whether there is growth in sales of the company in the past.
 Companies that has a product or a service which is high in demand usually shows high
growth in sales in the past.
  The company has grown its sales from (₹ 2,469 crore in FY2011 to (₹ 5,511 crore in FY2020,
which turns out to be a compound annual growth rate (CAGR) of 9% YoY.
 An Investor should prefer companies that have grown at least at the rate of inflation or more
in past.
 One should note that very high growth rate e.g. 50% or more are unsustainable in long run.

( ) −1 ; where ' N ' is the number of periods .

1
Starting Value
Note : CAGR= N
Ending value

“Analysis of P&L: Profitability”

(₹ Crores/10 Million) Jun- Jun- Jun- Jun- Jun- Mar Mar Mar Mar- Mar-
11 12 13 14 15 -16 -17 -18 19 20
246 292 340 396 425 296 446 496 5612 5511
Sales (A) 9 8 4 1 4 0 2 9
Operating Profit (B) 357 472 536 589 666 460 762 787 785 835
Operating Profit Margin (B/A) 14% 16% 16% 15% 16% 16% 17% 16% 14% 15%
Other (non-operating) Income
(C) 6 6 3 6 5 (2) 8 38 89 32
EBITDA (D = B+C) 363 478 539 595 671 458 770 825 874 867
Interest (E) 44 58 55 79 60 32 34 21 26 20
Depreciation (F) 62 72 82 102 139 105 154 167 184 206
Profit before tax (G = D-E-F) 257 348 402 414 472 321 582 637 664 641
Tax (H) 88 115 133 140 160 118 206 206 216 174
Net profit after tax (I = G-H) 169 233 269 274 312 203 376 431 448 467
Net Profit Margin (I/A) 7% 8% 8% 7% 7% 7% 8% 9% 8% 8%

 Profitability can be measured in two prominent measures Operating Profit Margin (OPM)
and Net Profit Margin (NPM).
 Operating Profit Margin (OPM) measures the portion of sales income that is remaining after
deducting costs of producing these sales e.g. raw material costs, employee costs, sales &
marketing costs, power and fuel costs etc. Operating profit does not factor in expenses like
depreciation of fixed assets, interest and tax expenses. Also, we do not include non-
operating/other income while calculating operating profit.
 Net Profit Margin (NPM) reflects the net profit that remains after a company has paid its
interest, tax and factored in depreciation. Net profit is final remnant after meeting all
expenses and is available with the company for reinvesting or distributing to shareholders as
a dividend.
 An investor’s aim is to find companies with good profitability, which has been able to sustain
in the past.
 Companies with high-profit margins are able to face tough times comfortably and still make
money for their shareholders
 We can see that the Operating Profit Margin (OPM) for Supreme Industries Ltd. Is almost
stable at the levels of 14-16% during FY2011-2020.
 Similarly, the Net Profit Margin (NPM) of the company is stable in the range of 8-10% over
the years.
  An investor should prefer companies that have stable or improving profit margin over the
companies with declining or fluctuating profit margin where the company may see profits in
some years and losses in other years.
 Methods resorted by companies to inflate Profits
o Playing around with expenses
o Playing around with profits and losses from investments
o Not making expenses that they are required to do
o Changing accounting policies whenever it suits them

“Analysis of P&L: Tax”

(₹ Crores/10 Million) Jun- Jun- Jun- Jun- Jun- Mar- Mar- Mar- Mar- Mar-
11 12 13 14 15 16 17 18 19 20
Profit before tax (A) 257 348 402 414 472 321 582 637 664 641
Tax (B) 88 115 133 140 160 118 206 206 216 174
Tax % (B/A) 34% 33% 33% 34% 34% 37% 35% 32% 33% 27%

 A company with good accounting and corporate governance standards would want to pay all
legitimate taxes to the government. In India, the corporate tax rate is 30% for Indian
companies and 40% for foreign companies.
 Abnormally low tax payouts should raise red flags and must be analysed.
 We can see that the company has been paying tax mostly at the rate of corporate tax. In
FY2020, the tax payout ratio has declined because of a change in the corporate tax rate in
India.
 Payment of taxes at the rate of corporate tax is a healthy sign. In case, an investor notices
that a company has its tax payout ratio lower than the standard corporate tax rate, then
he/she should read the annual report of the company in detail to find out the reasons for the
difference tax rate.
 Most of the times, a lower tax payout ratio may be linked to the following reasons:
o Tax incentives available to the company due to operations in SEZ etc.
o Export incentives provided by the govt.
o Tax-free income like interest on the investments done by the company in tax-free
bonds.
o Income that is taxed at a lower rate like short-term capital gains on investments like
stocks and equity mutual funds etc.
o Therefore, an investor should analyse the annual report in detail to find out the
reasons for a lower tax payout ratio.
o In recent years, due to the application of Indian Accounting Standards (IndAS),
companies disclose a tax payout reconciliation table in the annual report, which
reconciles the differences between the standard corporate tax rate and the actual
tax payout ratio of the company in the profit and loss statement.
“Analysis of P&L: Interest Coverage”

(₹ Crores/10 Million) Jun Jun Jun Jun Jun Mar Mar Mar Mar Mar-
-11 -12 -13 -14 -15 -16 -17 -18 -19 20
35 47 53 58 66
Operating Profit (A) 7 2 6 9 6 460 762 787 785 835
Interest Expense (B) 44 58 55 79 60 32 34 21 26 20
Interest Coverage Ratio (C=A/B) 8 8 10 7 11 14 22 37 30 42

51 35 47 47 39
Total Debt (D) 4 1 0 3 3 412 279 250 160 440
10
Assumed Interest Rate (E) %
Interest Outgo (F=D*E) 51 35 47 47 39 41 28 25 16 44
Interest Coverage on Outgo
(G=A/F) 7 13 11 12 17 11 27 31 49 19

 Interest coverage indicates whether the operating profits generated by the company are
sufficient to pay interest to the lenders for the funds it has borrowed from them.
 An investor should look out for companies that have interest of at least 3. It implies that they
make an operating profit of at least ₹3 whereas their interest expense is ₹1. Higher interest
ratio provides a cushion during bad economic times and the company would not find it
difficult to service its debt even during bad times.
 While calculating the interest coverage ratio, an investor should keep in mind that the
interest expense shown in the P&L statement is after deducting the capitalised interest.
 The capitalised interest is that portion of the total interest, which the company pays on the
debt taken for construction of plant and machinery. Until the plant is operational, a
company can capitalize interest on the debt taken for the construction of the plant. As a
result, the interest expense in the P&L may not represent the complete interest outgo of the
company in any year.
 To mitigate this issue, in our analysis, we assume a sample interest and calculate the interest
outgo for the company in any year based on that assumed rate. In the above table, Interest
Outgo (F) is calculated based on an assumed interest rate of 10%.
 Thereafter, we calculate the interest coverage ratio by dividing the operating profit with this
interest outgo, which gives us a more realistic figure of the interest coverage ratio for the
company.
“Analysis of Balance Sheet: Debt to Equity Ratio”

(₹ Crores/10 Million) Jun Jun Jun Jun- Jun- Mar Mar Mar Mar Mar-
-11 -12 -13 14 15 -16 -17 -18 -19 20
Total Debt (A) 514 351 470 473 393 412 279 250 160 440

Equity Share Capital (B) 25 25 25 25 25 25 25 25 25 25

101 118 129 167 186 212
Reserves (C) 522 671 854 4 6 0 0 9 9 2236
103 121 131 169 189 215
Total Equity (D= B+C) 547 696 879 9 1 5 5 4 4 2261

Debt to Equity Ratio (E=

A/D) 0.9 0.5 0.5 0.5 0.3 0.3 0.2 0.1 0.1 0.2

 D/E ratio measures the composition of the funds that the company has utilised to buy its
assets.
 The company uses its assets to produce goods & services that bring the sales revenue to the
company.
 D/E ratio shows how much of the total funds employed by the company is its own
(shareholder’s funds) and how much is borrowed from other lenders.
 D/E of 1 means that 50% of funds are brought by shareholders and rest 50% is borrowed
from lenders.
 During bas times when the company might not be able to make good profits, the lender will
ask for their money and the company might have to sell its assets in distress to pay back the
lenders. If the company is not able to find buyers willing to pay sufficient money, it can
become bankrupt. Therefore, investors should prefer companies with low debt to equity
ratio.
 Some investors like to use secured or long term debt for calculating D/E ratio. However,
taking total debt for calculating D/E ratio is preferable.

“Analysis of Balance Sheet: Current Ratio”

(₹ Crores/10 Million) Jun- Jun- Jun- Jun- Jun- Mar Mar Mar Mar Mar-
11 12 13 14 15 -16 -17 -18 -19 20
Inventory (A) 345 314 467 498 465 558 777 697 750 891
Trade Receivables (B) 153 171 203 235 238 236 275 382 387 313
Cash & Bank Balance (C) 14 14 24 27 182 29 80 36 31 231
Current Assets (D = 113 111 116
A+B+C) 512 499 694 760 885 823 2 5 8 1435

Trade Payables (E) 161 217 349 278 300 344 453 490 557 548
Current Ratio (F = D/E) 3.2 2.3 2.0 2.7 3.0 2.4 2.5 2.3 2.1 2.6

 Current Assets (CA) are the assets that are consumed within the next year. They include
inventory that gets consumed and gets sold as a finished product within a year, cash &
similar investments kept by the company to meet day to day requirements and money due
from customers (accounts receivable or debtors) and loans given to different parties that are
expected to be received back within a year.
 Current Liabilities (CL) include payables within the next one year and the short-term
provisions.
 The current ratio of >1 means that the company has CA which exceed CL and that the
company would be able to pay off its near term liabilities by the money it would receive
from current assets.
 Investors should look for companies that have a current ratio of atleast 1.25 or more.

“Analysis of Cash Flow Statement”

(₹ Crores/10 Million) Jun- Jun- Jun- Jun- Jun- Mar Mar Mar Mar Mar
11 12 13 14 15 -16 -17 -18 -19 -20
Cash from Operating
Activity (CFO) 170 352 406 325 601 296 465 508 556 537
Cash from Investing Activity
(CFI) -240 -64 -363 -134 -186 -218 -202 -267 -240 -194
Cash from Financing Activity
(CFF) 66 -287 -32 -188 -260 -234 -210 -284 -316 -156
Net Cash Flow
(CFO+CFI+CFF) -4 1 11 3 155 -156 53 -43 0 187
Cash & Eq. at the end of
year 14 14 24 27 182 29 80 36 37 231

 Cash from Operations (CFO) provides details of the cash that a company has generated in
the last financial year from operation.
 Cash-flow from investing Activities (CFI) includes details of cash used in making investments
or received from selling investments.
 Cash-flow from Financing Activities (CFF) is cash raised from financial institutions as
borrowings or repaid to them during the last year.
 An investor should focus on companies, which generate a good amount of cash flow from
operations (CFO) that can take care of their requirements of investments (CFI) and
repayment of debt (CFF).
 If an investor can find a company that generates so much cash that after taking care of CFI
and CFF, it still has surplus left, that’s a great situation.
 We can see that the company has been generating a good amount of cash from operations
(CFO) year on year.
  We can observe that throughout the last 10-years, the company was expanding its
manufacturing capacities as reflected in the negative cash flow from investing (CFI).
However, almost all money for investment in the plant & machinery has been generated
from its operations. This is because the cash inflow under CFO of the company has been
consistently higher than the cash outflow under CFI.
 As a result, an investor can appreciate that the surplus CFO left after taking care of outflow
under CFI has been used by the company to pay dividends to its shareholders as well as to
repay its debt.

“Analysis of Cash Flow Statement: Cumulative PAT vs Cumulative CFO”

(₹ Crores/10 Jun- Jun- Jun- Jun- Jun- Mar- Mar- Mar- Mar- Mar- Total
Million) 11 12 13 14 15 16 17 18 19 20 FY2011-
2020
Net profit after tax
(PAT) 196 242 290 283 322 221 430 432 449 467 3332
Cash from
operating activities
(CFO) 170 352 406 325 601 296 465 508 556 537 4216

 A company that sells any product today might not receive its payment immediately.
However, it is legitimately eligible to receive it. Therefore accounting standards allow it to
report this sale and its profit in P&L.
 However, the money received from the buyer will be reflected in CFO only when the money
is actually received from the buyer. Therefore, if we compare PAT and CFO for any one year,
they would differ from each other. However, over a long time, cumulative PAT and CFO
should be similar.
 If cumulative PAT is similar to CFO, it means that the company is able to collect its profits in
actual cash from its buyers. If CFO is abysmally lower than PAT, it would mean that either
the company though legitimately eligible to receive money from the buyer, is not able to
collect it or the profits are fictitious. In either case, the investor should avoid such a
company.

Summary of the “8 Steps to Financial Analysis of any Company”

 Sales growth: Look for high and sustainable growth >15% per year. The growth rate of 50%
is unsustainable in long term.
 Profitability: Look for high and sustainable OPM and NPM. NPM of >8% is preferable.
 Tax payout ratio: Tax rate should be near the general corporate tax rate unless some
specific tax incentives are applicable to the company.
 Interest coverage: Look for companies with an interest coverage ratio of >3.
 Debt to Equity ratio: Look for companies with low/nil debt. Preferably D/E<0.5
 Current ratio: Look from companies with CR>1.25.
 Cash flow: Positive CFO is necessary. It’s great if CFO meets the outflow for CFI and CFF.
 Cumulative PAT vs Cumulative CFO: Look for companies where cumulative PAT and CFO are
similar for the last 10 years.

***