Monday, January 31, 2011

What is the objective behind analysis of financial statements?

Objective (To know about)
Relevant indicator/Remarks

1.       Financial position of the company

Net worth, i.e., share capital, reserves and unallocated surplus in balance sheet carried down from profit and loss appropriation account.  For a healthy company, it is necessary that there is a balance struck between dividend paid and profit retained in business so much the net worth keeps on increasing.

2.     Liquidity of the company, i.e., whether the company is in a position to meet all its short-term liabilities (also called “current liabilities”) with the help of its current assets

Current ratio and quick ratio or acid test ratio.  Current ratio = Current assets/current liabilities.  Quick ratio = Current assets (-) inventory/ current liabilities. Current ratio should not be too high like 4:1 or 5:1 or too low like less than 1.5:1.  This means that the company is either too liquid thereby increasing its opportunity cost or not liquid at all, both of which are not desirable. Quick ratio could be at least 1:1. Quick ratio is a better indicator of liquidity position.

3.     Whether the company has acquired new fixed assets during the year and if so, what are the sources, besides internal accruals to finance the same?

Examination of increase in secured or unsecured loans for this purpose.  Without adequate financial planning, there is always the risk of diverting working capital funds for fixed assets. This is best assessed through a funds flow statement for the period as even net cash accruals (Retained earnings + depreciation + amortisation) would be available for fixed assets.

4.     Profitability of the company in general and operating profits in particular, i.e., whether the main operations of the company like manufacturing have been in profit or the profit of the company is derived from other income, i.e., income from investment in shares/debentures etc.

Percentage of profit before tax to total income including other income, like dividend or interest income.  Operating profit, i.e., profit before tax (-) other income as above as a percentage of income from the main operations of the company, be it manufacturing, trading or services.


5.     Relationship between the net worth of the company and its external liabilities (both short-term and long-term). What about only medium and long-term debts?

Debt/Equity ratio, which establishes this relationship.  Formula = External liabilities + preference share capital /net worth of the company (-) preference share capital (redeemable kind).  From the lender’s point of view, this should not exceed 3:1.  Is there any sharp deterioration in this ratio?  Is so, please be on guard, as the financial risk for the company increases to that extent.
For only medium and long-term debts, it cannot exceed 2:1.

6.     Has the company’s investments in shares/debentures of other companies reduced in value in comparison with last year?

Difference between the market value of the investments and the purchase price, which is theoretically a loss in value of the investment.  Actual loss is booked upon only selling.  The periodic reduction every year should warn us that at the time of actual sales, there would be substantial loss, which immediately would reduce the net worth of the company. Banks, Financial Institutions, Investment companies or NBFCs would be required to declare their investment every year in the balance sheet at cost price or market price whichever is less.

7.     Relationship between average debtors (bills receivable) and average creditors (bills payable) during the year.

Average debtors in the year/average creditors in the year.  This should be greater than 1:1, as bills receivable are at gross value {cost of development (+) profit margin}, whereas; creditors are at purchase price for software or components, which would be much less than the final sales value.  If it is less than 1:1, it shows that while receivable management is quite good, the company is not paying its creditors, which could cause problems in future.  Too high a ratio would indicate that receivable management is very poor.

8.     Future plans of the company, like acquisition of new technology, entering into new collaboration agreement, diversification programme, expansion programme etc.

Directors’ report.  This would reveal the financial plans for the company, like whether they are coming out with a public issue/Rights issue etc.

9.     Has the company revalued its fixed assets during the year, thereby creating revaluation reserves, without any inflow of capital into the company, as this is just an entry passed in the books?

Auditors’ comments in the “Notes to Accounts” relevant for this.  Frequent revaluation is not desirable and healthy.

10.  Whether the company has increased its investment and if so, what is the source for it?  What is the nature of investment?  Is it in tradable securities or long-term
     Securities, which can have a lock-in-period and cannot be liquidated in the near future?

Increase in amount of investment in shares/debentures/Govt. securities etc. in comparison with last year and any investment within group companies?  Any undue increase in investment should put us on guard, as working capital funds could have been diverted for it.

11.   Has the company during the year given any unsecured loans substantially other than to employees of the company?

Any increase in unsecured loans.  If the loans are to group companies, then all the more reason to be cautious.  Hence, where the figures have increased, further probing is called for.

12.  Are the company’s unsecured loans (given) not recoverable and very old?

Any comments to this effect in the notes to accounts should put us on caution.  This examination would indicate about likely impact on the future profits of the company.

13.  Has the company been regular in payment of its dues on account of loans or periodic interest on its liabilities?

Any comments about over dues as in the “Notes to Accounts” should be looked into.  Any serious default is likely to affect the “credit rating” of the company with its lenders, thereby increasing its cost of borrowing in future.

14.  Has the company defaulted in providing for bonus liability, P.F. liability, E.S.I. liability, gratuity
     liability etc?

Any comments about this in the “Notes to Accounts” should be looked into.

15.  Whether the company is holding very huge cash, as it is not desirable and increases the opportunity cost?

Cash balance together with bank balance in current account, if any, is very high in the current assets.

16.  How many times the average inventory has turned over during the year?

Relationship between cost of goods sold and average inventory during the year (only where cost of goods sold cannot be determined, net sales can be taken as the numerator).  In a manufacturing company, which is not in capital goods sector, this should not be less than 4:1 and for a consumer goods industry, this should be higher even.  For a capital goods industry, this would be less.

17.  Has the company issued fresh share capital during the period and what is the purpose for which it has raised equity capital?  If it was a public issue, how did it fare in the market?

Increase in paid-up capital in the balance sheet and share premium reserves in case the issue has been at a premium.

18.  Has the company issued any bonus shares during the year?

Increase in paid-up capital and simultaneous reduction in general reserves. Enquiry into the company’s ability to keep up the dividend rate of the immediate past.

19.  Has the company made any rights issue in the period and what is the purpose of the issue?  If it was a public issue, how did it fare in the market?

Increase in paid-up capital and share premium reserves, in case the issue has been at a premium.

20.What is the proportion of marketable investment to total investment and whether this has decreased in comparison with the previous year?

Percentage of marketable investment to total investment and comparison with previous year.  Any decrease should put us on guard, as it reduces liquidity on one hand and increases the risk of non-payment on due date, especially if the investment is in its own subsidiary or group companies, thereby forcing the company to provide for the loss.

21.  What is the increase in sales income over last year in % terms? Is it due to increase in numbers or change in product mix or increase in prices of finished products only?

Comparison with previous year’s sales income and whether the growth has been more or less than the estimate.

22.What is the amount of provision for bad and doubtful debts or advances outstanding?

In percentage terms, how much is it of total debts outstanding and what are the reasons for such provision in the notes to accounts by the auditors?

23.What is the amount of work in progress as shown in the Profit and Loss Account?

Is there any comment about valuation of work in progress by the auditors?  It can be seen that profit from operations can be manipulated by increase/decrease in closing stocks of both finished goods and work in progress.

24.Whether the company is paying any lease rentals and if so what is the amount of lease liability outstanding?

Examination of expenses schedule would show this.  What is the comment in notes to accounts about this?  Lease liability is an off-balance sheet item and hence this examination, to ascertain the correct external liability and to include the lease rentals in future also in projected income statements; otherwise, the company may be having much less disclosed liability and much more lease liability which is not disclosed.  This has to be taken into consideration by an analyst while estimating future expenses for the purpose of estimating future profits.

25.Has the company changed its method of depreciation on fixed assets, due to which, there is an impact on the profits of the company? 

Auditors’ comments on “Accounting” policies.  Change over from straight-line method to written down value method or vice-versa does affect the deprecation charge for the year thereby affecting the profits during the year of change.

26.If it is a manufacturing company, whether the % of materials consumed is increasing in relation to sales?

Relationship between materials consumed during the year and the sales.

27.Has the company changed its method of valuation of inventory, due to which there is an impact of the profits of the company?

Auditors’ comments on “Accounting” policies.

28.Whether the % of administration and general expenses has increased during the year under review?

Relationship between general and administrative expenses during the year and the sales.  In case there is any extraordinary increase, what are the reasons therefore?

29.Whether the company had sufficient income to pay the interest charges?

Interest coverage ratio = earnings before interest and tax/total interest on all short-term and long-term liabilities.  Minimum should be 3:1 and anything less than this is not satisfactory.

30.Whether the finance charges have gone up disproportionately as compared with the increase in sales income during the same period?

Relationship between interest charges and sales income – whether it is consistent with the previous year or is there any spurt?
Is there any explanation for this, like substantial expansion or new project or diversification for which the company has taken financial assistance?  While a benchmark % is not available, any level in excess of 6% calls for examination.                         

31.  Whether the % of employee costs to sales has increased?

Relationship between “payment to and provision for employees” and the sales.  In case any undue increase is seen, it could be due to expansion of activity etc. that would be included in the Directors’ Report.

32.Whether the % of selling expenses in relation to sales has gone up?

Relationship between “selling and marketing” expenses and the sales.  Any undue increase could either mean that the company is in a very competitive industry or it is aggressive to increase its market share by adopting a marketing strategy that would increase the marketing expenses including offer of higher commission to the intermediaries like agents etc.

33.Whether the company had sufficient internal accruals {Profit after tax (-) dividend (+) any non-cash expenditure like depreciation, preliminary expenses write-off etc.} to meet repayment obligation of principal amount of loans, debentures etc.?

Debt service coverage ratio = Internal accruals (+) interest on medium and long-term external liabilities/interest on medium and long-term liabilities (+) repayment of medium and long-term external liabilities.  The term-lending institution or bank looks for 1.75:1 on an average for the loan period.  This is a very critical ratio to indicate the ability of the company to take care of its obligation towards the loans it has taken both by way of interest as well as repayment of the principal.

34.Return on investment in business to compare it with return on similar investment elsewhere.

Earnings before interest and tax/average total invested capital, i.e., net worth (+) debt capital.  This should be higher than the average cost of funds in the form of loans, i.e., interest cost on loans/debentures etc.

35.Return on equity (includes reserves and surplus)

Profit after tax (-) dividend on preference share capital/net worth (-) preference share capital (return in percentage).  Anything less than 15% means that our investment in this company is earning less than the average return in the market.

36.How much earning has our share made? (EPS)

Profit after tax (-) dividend on preference share capital/number of equity shares.  In terms of percentage anything less than 40% to 50% of the face value of the shares would not go well with the market sentiments.

37.Whether the company has reduced its dividend payout in comparison with last year?

Relationship between amount of dividend payout and profit after tax last year and this year.  Is there any reason for this like liquidity crunch that the company is experiencing or the need for conserving cash for business activity, like purchase of fixed assets in the immediate future?

38.Is there any significant increase in the contingent liabilities due to any of the following?
     Disputed central excise duty, customs duty, income tax, octroi, sales tax, contracts remaining unexecuted, guarantees given by the banks on behalf of the company as well as the guarantees given by the company on behalf of its subsidiary or associate company, letter of credit outstanding for which goods not yet received etc.

“Notes on Accounts” as given at the end of the accounts. 
Any substantial increase especially in disputed amount of duties should put us on guard.

39.               Has the company changed its policy of outsourcing its work from vendors and if so, what are the reasons?

Substantial change in vendor charges, or subcontracting charges.

40.               Is there any substantial increase in charges paid to consultants?

Increase in consultancy charges.

41.     Has the company opened any branch office in the last year?

Directors’ Report or sudden spurt in general and administration expenses.


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Saturday, January 29, 2011

How to Read Financial Reports for Cash Flow

You’re interested in a Stock, so you’re reading its financial reports. Part of the test of a viable operation is having enough cash to keep the company going. The amount of money that flowsinto and out of a business during the time period being reported,The following formulas give you various tests of a company’s cash position:

·         Free cash flow shows you how much money a company earns from its operations that can actually be put in a savings account for future use.
Free cash flow = Cash provided by operating activities – Capital expenditures – Cash dividends
·         Cash return on sales looks specifically at how much cash is being generated by sales.
Cash return on sales = Cash provided by operating activities ÷ Net sales
·         Current cash debt coverage ratio lets you know whether a company has enough cash to meet its short-term needs.
Current cash debt coverage ratio = Cash provided by operating activities ÷ Average current liabilities
·         Cash flow coverage ratio finds out whether a company has enough money to cover its bills and finance growth.
Cash flow coverage ratio = Cash flows from operating activities ÷ Cash requirements

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Friday, January 28, 2011

How to Read Financial Reports for Liquidity Ratios

If a company doesn’t have cash on hand to cover its day-to-day operations, it’s probably on shaky ground. As you read the financial report, use the following formulas to find out whether a company has plenty of liquid (easily converted to cash) assets.

·         Current ratio gives you a good idea of whether a company will be able to pay any bills due over the next 12 months with assets it has on hand.
Current ratio = Current assets ÷ Current liabilities
·         Quick ratio or acid test ratio shows a company’s ability to pay its bills using only cash on hand or cash already due from accounts receivable. It doesn’t include money anticipated from the sale of inventory and the collection of the money from those sales.
Quick ratio = Quick assets ÷ Current liabilities
·         Interest coverage ratio lets you know whether a company is bringing in enough money to pay interest on whatever outstanding debt it has.
Interest coverage ratio = EBITDA ÷ Interest expense
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Today's Bse Nse Stock picks

Nifty, Bank Nifty & M&M

Current: 5,604 (Feb future: 5,630),
Target: 5,475 (3-session target)

The index saw a new 2011 low and also broke below its own 200 Day Moving Average. This is not confirmed yet but the pattern suggests a drop till 5,475 in the next three sessions. A bounce could pullback till 5,750. Simplest is a short futures position, with a stop loss at 5,650. A preferred strategy is the bearspread of long 5,500p (82) and short 5,400p (55) - cost:27; Maximum return: 73. A "zero-delta" long-short strangle of long 5,500p (82) and long 5,700c (94) and short 5,400c (55) and short 5,800c (55) costs 66 with breakevens at 5,434; 5,766. It's low-risk if you wish to hold till settlement..

Current: 10,676 (Feb futures 10,732),
Target: 10,500 (10,300, 3-session target)

The financial index broke downside targets (10,800) set on Jan 24 closing. If support at 10,600-10,625 is broken, secondary support at 10,475-10,500 will be tested. There's a good chance of a drop till 10,300 in a three-session timeframe. Keep a stop at 10, 825 and short. Add to the position between 10,550 and 10,600. Either clear at 10,500, or hold with a target of 10,300 if you can wait three sessions.

Current Price: Rs 733,
Target Price: Rs 695

The stock is at a key support of Rs 725-735 after a two-session drop from Rs 799. It if falls below Rs 725, it could till Rs 680-690. Keep a stop at Rs 745 and go short. Add to the position between Rs 715 and Rs 720. Start booking profits below Rs 695. If the Rs 745 stop is broken, be prepared for a jump back to Rs 770.          

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Thursday, January 27, 2011

15 Things I Look at Before Trading a Stock

15 Things I Look at Before Trading a Stock

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How to Financial Reports for Profitability Ratios

You read financial reports to get a sense of a company’s financial position and how viable it is in the marketplace. You can test a company’s money-making prowess by using the following important formulas:

·  Price/earnings ratio compares the price of a stock to its earnings. A ratio of 10 means that for every $1 in company earnings per share, people are willing to pay $10 per share to buy the stock.
Price/earnings ratio = Market value per share of stock ÷ Earnings per share of stock
· Dividend payout ratio shows the amount of a company’s earnings that are paid out to investors. Use it to determine the actual cash return you get by buying and holding a share of stock.
Dividend payout ratio = Yearly dividend per share ÷ Earnings per share
·  Return on sales tests how efficiently a company is running its operations by measuring the profit produced per dollar of sales.
Return on sales = Net income before taxes ÷ Sales

·  Return on assets shows you how well a company uses its assets. A high return on assets usually means the company is managing its assets well.
Return on assets = Net income ÷ Total assets
· Return on equity measures how well a company earns money for its investors.
Return on equity = Net income ÷ Shareholders’ equity

· The gross margin gives you a picture of how much revenue is left after all the direct costs of producing and selling the product have been subtracted.
Gross margin = Gross profit ÷ Net sales or revenues

· The operating margin looks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product.
Operating margin = Operating profit ÷ Net sales or revenues

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Tuesday, January 25, 2011

How to read Financial Annual Report

If you’re new to investing & looking at a business with an interest in investing in Bse/Nse stocks, you need to read its financial reports. Of course,  you don’t need to read everything, just the key parts. These Financial statements will help you figure profitability and liquidity ratios and get a better sense of cash flow .

Reading a companys financial report is never the easiest thing to do, and annual reports can be especially daunting. You may be relieved to know that you don’t actually need to scour every page. The following parts best serve to give you the big picture .

1.       The Profit & Loss statement on the year passed and the Last Quarter;
2.     The Balance Sheet ;
3.     The Directors’ Report on the year passed and the future plans;
4.     Annexure to the Directors’ Report containing particulars regarding     conservation of energy etc;
5.     Auditors’ Report as per the Manufacturing and Other Companies   (Auditors’ Report) Order, 1998) along with Annexure;
6.     Schedules to Balance Sheet and Profit and Loss Account;
7.     Accounting policies adopted by the company and notes on accounts giving details   about changes if any, in method of valuation of stocks, fixed assets, method of depreciation on fixed assets, contingent liabilities, like guarantees given by the banks on behalf of the company, guarantees given by the company, quantitative details regarding performance of the year passed, foreign exchange inflow and outflow etc. and
8.     Statement of cash flows for the same period for which final accounts have been presented.

   Key pointers to balance sheet and profit and loss statements:

  •      A balance sheet represents the financial affairs of the company and is also referred to as “Assets and Liabilities” statement and is always as on a particular date and not for a period.
  •     A profit and loss account represents the summary of financial transactions during a particular period and depicts the profit or loss for the period along with income tax paid on the profit and how the profit has been allocated (appropriated).
  •    Net worth means total of share capital and reserves and surplus. This includes preference share capital unlike in Accounts preference share capital is treated as a debt. For the purpose of debt to equity ratio, the necessary adjustment has to be done by reducing preference share capital from net worth and adding it to the debt in the numerator.
  •      Reserves and surplus represent the profit retained in business since inception of business.  “Surplus” indicates the figure carried forward from the profit and loss appropriation account to the balance sheet, without allocating the same to any specific reserve.  Hence, it is mostly called “unallocated surplus”.  The company wants to keep a portion of profit in the free form so that it is available during the next year for appropriation without any problem. In the absence of this arrangement during the year of inadequate profits, the company may have to write back a part of the general reserves for which approval from the board and the general members would be required.
  • Secured loans represent loans taken from banks, financial institutions, debentures (either from public or through private placement), bonds etc. for which the company has mortgaged immovable fixed assets (land and building) and/or hypothecated movable fixed assets (at times even working capital assets with the explicit permission of the working capital banks)

Usually, debentures, bonds and loans for fixed assets are secured by  fixed assets, while loans from banks for working capital, i.e., current assets are secured by current assets.  These loans enjoy priority over unsecured loans for settlement of claims against the company.

  Unsecured loans represent fixed deposits taken from public (if any) as per the provisions of Section 58 (A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no security has been offered. 

Such unsecured loans rank second and subsequent to secured loans for settlement of claims against the company.  There are other unsecured creditors also, forming part of current liabilities, like, creditors for purchase of materials, provisions etc.

    Gross block = gross fixed assets mean the cost price of the fixed assets.  Cumulative depreciation in the books is as per the provisions of The Companies Act, 1956, Schedule XIV.  It is last cumulative depreciation till last year + depreciation claimed during the current year.  Net block = net fixed assets mean the depreciated value of fixed assets.

     Capital work-in-progress – This represents advances, if any, given to building contractors, value of building yet to be completed, advances, if any, given to equipment suppliers etc.  Once the equipment is received and the building is complete, the fixed assets are capitalised in the books, for claiming depreciation from that year onwards.  Till then, it is reflected in the form of capital work in progress.

     Investments – Investment made in shares/bonds/units of Unit Trust of India etc. This type of investment should be ideally from the profits of the organisation and not from any other funds, which are required either for working capital or capital expenditure.  They are bifurcated in the schedule, into “quoted and traded” and “unquoted and not traded” depending upon the nature of the investment, as to whether they can be liquidiated in the secondary market or not.

     Current assets – Both gross and net current assets (net of current liabilities) are given in the balance sheet.

      Miscellaneous expenditure not written off can be one of the following –
Company incorporation expenses or public issue of share capital, debenture etc. together known as “preliminary expenses” written off over a period of 5 years as per provisions of Income Tax.  Misc. expense could also be other deferred revenue expense like product launch expenses.
Other income in the profit and loss account includes income from dividend on share investment made in other companies, interest on fixed deposits/debentures, sale proceeds of special import licenses, profit on sale of fixed assets and any other sundry receipts.

     Provision for tax could include short provision made for the earlier years.

     Provision for tax is made after making all adjustments for the following:

·        Carried forward loss, if any;
·        Book depreciation and depreciation as per income tax and
·        Concessions available to a business entity, depending upon their activity (export business, S.S.I. etc.) and location in a backward area (like Goa etc.)

    As per the provisions of The Companies Act, 1956, in the event of a limited company declaring dividend, a fixed percentage of the profit after tax has to be transferred to the General Reserves of the Company and entire PAT cannot be given as dividend.

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