I. Balance Sheet/Financial Position
One important thing to remember is that Balance Sheet only reveals the firm's worth on the date when it is prepared. It does not reveal the data to date profitability of the firm.
a. Significance of RE and Reserves Surplus
EBITDA is a measure of a company's profitability which shows the Earnings before deducting the Interest, tax, depreciation, and amortization. In layman's words, you may call it gross profit. After deducting ITDA what remains is called Net Profit. This entire net profit belongs to the Owners i.e. the Shareholders. However, not a good company will give away the entire Net profit to the shareholders. A small portion of Net profit may be invested to the company.
This held-back profit is called retained earnings. Where does it go? it goes to the company's bank or as an investment (fixed assets). Nevertheless, the money belongs not to the company but to the shareholders. It is reflected as "Reserve and Surplus"* or EQUITY post minus Share Capital.
*This term somehow is not popular anymore.
Generally, If reserves and surplus or the Fixed Assert are NOT increasing year over year, money is not coming in, company is NOT growing and Shareholders wealth is NOT increase
b. Significance of the Debt-Equity Ratio
The ratio of Debt and Equity.
If you are looking at a balance sheet and you find D/E is quite high, say higher than 1:4 or 1:3. Then you should understand that the company is carrying High Risk, which means it can earn very high profit or sustain high losses. In other words, If you want to take a high risk for a high gain, then invest in high debt company. However,
If you want to have a SAFE investment, then look for a company with a low debt to equity ratio.
c. Significance of Working Capital
In a simple way, Current liabilities (CL) and assets (CA) are used for a company's operating cycle. CA - CL = Working Capital. Working capital means money available for working during operating cycle. It also means net amount remaning in a company for sustenance during the month. (Note that financial statement is made until the end of the period, WC for the next period).
Points:
Available money (WC) is less than required money: NOT a good situation. Reflects bad management. Will lead to borrowing. [LOWER PROFITS and Lesser returns to Share holders]
WC is the same as required money: IDEAL but seldom happen
WC is a LITTLE more than required: DESIRABLE SITUATION. Reflects good planning and good management.
WC is MUCH more than required: NOT DESIRABLE. Excess could have been invested in better long term assets rather than keeping as current assets.
Lesser the requirement of WC, better for the company. However, when comparing, compare on level playing field. Do not compare a drwaft with a giant
Significance of the Relation of Assets and Liabilities
Golden rule:
Long-term assets must be financed through long-term sources of money. Short term (current) assets should be adequate to repay short term (current) Liabilities
*Short term asset > short term liabilities -> current ratio more than 1
II. Income Statement/ Profit or Loss Statement
In General, there are 'top line' (Sales) and 'bottom line' (Net Profit). To increase the bottom line, it can be achieved by increasing the top line or decreasing the expense.
Crowd Psychology & Speculative Aspects of Top and Bottom Line
The Top Line is a lesser secret and the Bottom Line is a bigger secret
On a quarterly timeframe, the market acts in consonance with Top Line and Reacts on Knowing the Bottom Line
The Top line is basically the sales and it is not very difficult to find the sales figures on a daily or weekly basis.
The Bottom line tells the actual Net Profit. The Bottom line is known only after the financial result is declared by the company.
Check the growth of the bottom line and the reason for the growth or decline. Figure out the significant sales, expense or cost.
III. Cash Flow Statement
Significance of Cash Flow Statement
The Cash Flow statement shows the amount of cash and cash equivalents entering and leaving a company over a given time period. The cash flow statement measures how well a company is able to manage its cash position or how well the company is able to generate cash to pay its debt obligations and fund its operating cost.
Being in Profit and having Cash in your account to pay for your expenses are entirely different things.
Parameters of a Cash Flow Statement
Cash can 'Flow in' or 'Flow out' as a result of Operating Activities (All activities in connection with the normal operations of the company), Investing Activities (All activities connected with the investment aspects of the company), Financing Activities (All activities in connection with raising money to run), and Any Other activities.
A Positive figure is not necessarily good and a negative figure is not necessarily bad.
The Negative sign on investing activities indicates an outflow of cash was more and this is not necessarily bad, rather it is good if it is likely to generate more profit in the future.
The Negative sign on Financing activities is the same, it is not necessarily bad. Ma be the company has repaid debt.
Analyse the latest cash flow statement but compare with past 5 years.
Don't get influenced by the +ve or -ve sign of the figures. Find out the reason. If the -ve figs in financial activities are due to interesnt payment, then it is not good but if it is due to dividend payment or reduction of debt, then it is good.
If a company is not investing adequetly and regulary, then it is not planning to grow.
A sudden huge investment is a likely sign of increased profit in future. Grab the opportunity. A huge positive figure in investment activity is likely due to dinvestment. May be good for future.
MOST important. Cash flow from operating activities must be positive and must be at least equal to more than the net profit. If it is short by more than 10%, it is a problem.
IV. Vertical Comparison for Good Stocks
From above explanations, here are some takeaways.
V. Ratio Analysis
Ratio analysis would make sense only after you have identified good stocks by analyzing the financial statements
Ratio analysis would then help you in comparing good stocks and selecting the best ones.
A ratio in isolation does not convey much unless it is compared with a competitor or a benchmark
Comparison of ratios may tell you whether a share is undervalued or overvalued but before investing, you need to find the reasons for the valuation and get convinced by those reasons
We need to look at financial statements and ratio analysis in a holistic manner. Everything is interconnected and interrelated.
Significance of Ratio Analysis
One ratio does not give the entire picture
If you are looking at profitability then you see profitability ratios.
If you are looking at liquidity then you see liquidity ratios.
If you want to know the risk then you look at leverage ratios.
Ratio analysis is a subject in itself. We shall focus only on those ratios which are most relevant from an investment analysis point of view:
Earning per Share (EPS)
Price to Earning Ratio (PE)
Debt Equity Ratio
Return on Equity (ROE)
Price to Book Value Ratio
Understanding Face Value, Book Value, and Market Value
Face Value = (Share Capital /Number of Oustanding Equity Shares)
Book Value = (Share Capital + Reserves and Surplus)/ Number of Outstanding equity shares
or
The face value of the shares does not change unless the shares are split by the company
Splitting of Shares does not change the equity capital or R&S but changes the number of outstanding shares, So the FV and BV will change proportionately
A dividend is declared on the FV irrespective of the BV and Market Value
The BV of shares will keep increasing with an increase in R&S. It will decrease when R&S are returned to the shareholders as dividends or bonus shares.
The most important thing which matters - The Market Price
BV is the true worth of the share in the books of account, so why is market price different from BV? Because, you Pay future or hope or potential of the company. The buyer MIGHT have 'High hopes' or 'Lack of Hopes'. Market price depens on the HOPES and Perception of the majority in the market. BUT THE PERCEPTION OF THE MAJORITY MAY NOT ALWAYS BE CORRECT.
However, the Financial Statements and Ratio analysis help you make a close to correct perception.
Earning per Share
Price to Earning Ratio
Example:
Let us average PE ratio for Auto Industries is 15
'X' Motors' PE ratio is 10, and 'Y' Motors' PE ratio is 25. It means that it has a market price of 10 times and 25 times the annual earnings, respectively.
Share X is undervalued. BUT WHY? Why perception of the market have a low expectation for the company?
Share Y is overvalued. BUT WHY? Why market has high expectation? Why does the market believe that the company will be doing good in the future?
We have to figure out the reason and analyze it.
In X case:
How much is it below average?
Has it been improving in the past?
Government policies? Industry outlook?
Management commentary? Reputable? Good?
Any restructuring or diversification?
If much below average and that too for the wrong reasons, then consider to buy it.
In Y case:
How much is it above average?
Is it volatile or consistent?
Government policies? Industry outlook?
Is the price news driven?
What are the risk factors?
If slightly above average and for right reasons, then consider to buy it.
Debt Equity Ratio
If Net Profit is higher than the rate of interest to be paid on debt, then debt is good. Otherwise not.
A High Debt equity ratio implies high risk. So with increase in debt equity ratio if the returns are also increasing, then you may like to invest in the High risk - High return venture. Otherwise not.
If Debt to Equity ratio is constantly increasing that means the company is borrowing more and more. With increased borrowing, if Net profit and (reserve and surplus) are also increasing then it is okay. If it is not then it is an alarming situation. Remain away from such a company.
Low debt equity ratio implies low risk. At the same time it also implies that the company is not able to take advantage of financial leverage.
A debt equity ratio of 1 is considered ideal. Less than one is not bad but more than 2 is very risky.
Return on Equity
ROE helps us in determining which company is generating better returns for its equity holders or owners in terms of percentage.
Price to Book Value Ratio
Represents a valuation of the company as per books. ie how much times its value in books the market is willing to pay?
Valuation and profitability must move in tandem. If PB increases, ROE must show a corresponding increase. If not, that means something wrong.
A high PB ratio with a low ROE usually indicates overvalued securities. A low PB ratio with a high ROE indicates undervalued securities which may be good to invest.
Current Ratio
Current ratio:
<1 is a dangerous situation and you may borrow at a high rate.
1 is just adequate but risky
More than 1 to 2 means that you are well within the comfort zone
More than 2 might indicate the poor management of money and resources. Excess money could have been better invested.
VI. The Futility of Timing the Market
Once you have identified a good stock, the biggest dilemma is when to buy it and at what cost. There are ways and means and technical analysis to do that but no guaranteed answer. If you are a long-term investor, do not try to time the market.
If you are a long-term investor:
in the past three months, if the stock price has gone up based on sales figures or top-line estimates, then don't buy it just before the result.
Immediately on the declaration of a result - if your pre-result analysis says the stock is good, the result is also good and the stocks shoot up by more than 10% - Hold on. Let it come back to pre result price.
Do not buy when the stock market is at its peak and your selected stock is also at its peak. Wait for the market to fall by at least 10%.
Do not buy when the liquidity in the market is at its peak
If your analysis says the stock is good and several experts on TV channels are also recommending the same stock then hold on for some time. Let is stabilize or correct to some extent before you buy.
Comments