Analyzing companies is not just about the numbers but about a plethora of qualitative factors. These are the factors which are more subjective in nature and are largely based on conditional probabilities. A lot of qualitative factors are hard to define but you can certainly sense it and you know it is there. You associate Hindustan Unilever with a great brand, Tata group with ethical business practices and Infosys with corporate governance. These are hard to quantify but in the final analysis they do make a substantive difference to the valuation of the company.
What Are The Key Qualitative Factors To Look For In A Company?
Qualitative factors are part of a company’s ethos and an integral part of their DNA. These qualitative factors could be attributed to some basic vision of the company; some corporate principles adhered to, a responsive team, ability to foresee change etc. Here are some key qualitative aspects that can impact company valuations.
- How effectively the company is adapting its business model to changes in tastes and preferences in the market? Is the company really ahead of the curve on this aspect?
- How the industry is getting disrupted and how the company is adapting to these changes? Is the company able to build advantages around these disruptions?
- Can the business continue its leadership position in the medium to long term and how is the company preparing for the future?
- How is the company tapping the future opportunities in the business, how is it sprucing execution skills and how it is adapting its product lines.
- How does the market rate the quality of the management and what is the succession plan in place at the top?
- Do customers look at the products of the company as a high-value or low value product and what is the company doing about this perception?
- How is the company taking care of its distributors, wholesalers, vendors and other channel partners?
- How is the organization structure of the company? Is it bulky or is it lean and mean? Is the organization structure in sync with the future plans of the company?
- What is the company’s strategy to manage risk of the business and does the top management get involved in business risk reduction?
- Does the company follow high standards of corporate governance in terms of disclosure, transparency and putting the interests of stakeholders on top?
This is a sample list but it will surely give an idea of how to go about evaluating the all-important qualitative aspects of the business.
Quantitative Aspects - How to Read the Income Statement
Income statement of a company or the P/L account is a consolidated periodic statement showing revenues, costs and profitability of a firm for any given period. Financial results are published each quarter by companies while audited financials are published annually. As part of the listing agreement, companies are required to file these financial statements with the stock exchange. Here are some of the important components of the P&L account.
Net Sales: refers to the revenues generated by the company from its core business of selling goods and services. Net sales are always presented net of GST costs.
Direct Costs: can be directly attributed to business. These include costs like raw material, factory wages, electrical costs, fuel costs etc. Lower the direct costs, higher the operating efficiency of the firm.
EBITDA: The Earnings before Interest, Tax, Depreciation and Amortization is the difference between Net Sales and Direct Costs. EBIDTA is a measure of the operating efficiency of the company and enables comparison of companies irrespective of capital structure.
Depreciation/ Amortization: is provided as a non-cash charge so that the tax shields on this depreciation can be used to create a reserve for the replenishment of machinery and equipment at a future date. When depreciation is deducted from EBITDA you get EBIT (Earnings before interest and tax)
Interest: is the cost of loans, bonds and other borrowings taken by the business. An increase in the interest cost is attributed to an increase or decrease in the debt outstanding or in the cost of funds. When interest is deducted from EBIT, you get PBT.
Profit before Tax (PBT): refers to the total profit of the company for the period after meeting all the expenses. It is the profit on which the company is liable to pay taxes to the government.
Profit after Tax (PAT): is the bottom line or the profit that the company finally makes after payout all costs. The company decides what part of this profit should be paid out as dividends and how much should be ploughed back into the business.
The income statement is a flow and measures how much profit was made during the period (one quarter or one full year). The income statement also presents the Basic EPS and the Fully Diluted EPS (after considering all potential dilutions of capital in the future). Income statement is important from an analytical point of view as it captures in a nutshell whether the business is profitable at an operational level or not.
Quantitative Aspects - How to Read the Balance Sheet
A Balance Sheet is a stock and is prepared at a point of time. Normally balance sheets in the Indian context are as of the 31st of March, which is when the financial year ends. Balance sheet is a consolidated statement of what the company owns and what it owes (both to its creditors and to it is shareholders). It therefore captures the sources of funds for a company and application of those funds at any point of time. Such sources and applications can either be long term or short term.
What is the break-up of the balance sheet?
For any business, the balance sheet is one of the main financial reports prepared by the accountant. Balance sheets have to be statutorily audited. The balance sheet consists of three major elements: assets, liabilities and owners' equity. If this were to be put in the format of an equation, then it can be written as "Asset = Liabilities + Owner's Equity". The balance sheet places a business' assets on the right side of the equation and the liabilities and owner’s equity on the left aide with the total amount on the assets and liabilities tallying.
Your balance sheets show the position of the company on a given day, including its total assets, liabilities and equity, which equals its net worth. Lenders commonly use financial statements to assess your company's creditworthiness. A high debt-to-assets or debt-to-equity ratio is a concern.
How to use the balance sheet to evaluate companies
As managers, you can use the statement to make decisions about what to do with assets, how to manage finances and whether to distribute any earnings to shareholders. Suppliers and possible investors are also potentially interested in the balance sheet information. Balance sheet is an important document for filing with the statutory authorities and also for any filing or funding activity. Here are some of the key aspects that the balance sheet captures.
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Value of Assets
The assets section shows what the company owns that have tangible value. It includes current assets, along with property and equipment, investments and intangible assets, and usually listed in order of liquidity. The current assets section is compared to current liabilities to figure out your basic liquidity, or ability to pay off short-term debt. Current assets include cash, securities and accounts receivable, which can all generally be converted to cash within 12 months. Plant and equipment are assets with a longer-term use that would generally take longer to sell. Longer-term assets are more often used to operate your business and these are the basic operating assets which generate sales revenues.
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Value of Liabilities
The liabilities section is divided into current and long-term liabilities. Current liabilities refer to debts due within the next 12 months. Notes payable and accounts payable are common short-term debt accounts. In addition, the short term portion of long term debt is also included here (debt maturing within next 1 year). High short-term debt obligations stifle growth and may put you in a financial bind. The company must also ensure that the short term debt is predominantly funded by current assets and not by long term assets. On the other hand, long-term debt includes loans for buildings and other long-term asset loans. This also includes long term bonds issued by the company to enhance its capital base. The balance sheet also gives an idea of how leveraged the company is to lenders over the long haul. Higher leverage adds to the financial risk of the company since debt is a servicing commitment. Higher debt payments reduce cash flow and limit growth. That is the reason for companies it is always better to keep debt under control.
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Owners Equity or net worth of the company
Owners' equity is also referred to as net worth or Shareholder equity. It is the difference between the total assets and all outside liabilities. In essence, whatever you have left if you were to sell all of your assets and pay off debt is the value of the company at the present time. That is also called the book value approach. Equity actually includes a variety of accounts, but most commonly it refers to paid-up capital and retained earnings. Paid-up capital is the par value of the stock multiplied by the number of shares issued. Retained earnings are the accumulated value of profits ploughed back into the business and have been collected and retained in the company over time. If you distribute dividends to owners or shareholders, this reduces the value of retained earnings. The second aspect of equity is the share premium reserve when the shares are issued at a premium. Both the retained earnings and share premium account are treated as free reserves and the company can even issue bonus shares with this money. Although the equity shareholders are the owners of the company, the company is legally a separate artificial legal person and the capital of equity shareholders has to be shown as capital to be serviced.
Quantitative Aspects - How to Read the Cash Flow Statement
You may at time wonder as to how can companies showing profits suddenly go bankrupt? This happened to companies like Dewan Housing and IL&FS within a short span of time. How did it happen to a business that was doing so well? The answer is that they were just not generating enough cash in the business. Generating cash is critical for the long term survival of any business. Bothe the P/L statement and Balance Sheet are prepared on an accrual basis and hence they do not differentiate between cash transactions and accrual transactions. Cash flow statement, as the name suggests, focuses on actual cash received and confirmed.
What is the basis of preparation of the cash flow statement?
Effectively, it presents the movement in cash and cash equivalents over the period i.e. it explains how the cash balance actually changed over the two years. Cash and cash equivalents generally consist of cash in hand; cash at bank and very short term investments that are highly liquid with very low risk of (therefore usually excludes investments in equity instruments and long term debt). Most often, the bank overdrafts in cases where they comprise an integral element of the organization's treasury management are also allowed to be included as cash in hand. While income statement and balance sheet are prepared under the accruals basis of accounting, it is necessary to adjust the amounts extracted from these financial statements in respect of non cash expenses. This is in order to present only the movement in cash inflows and outflows during a period. All cash flows are classified under operating, investing and financing activities and these 3 segments are discussed elaborately bellow.
Cash flow from operating activities
Cash flow from operating activities presents the movement in cash during an accounting period from the primary revenue generating activities of the entity, which is the core product the company manufactures or the core service that the company provides. For instance, operating activities of a hotel will include cash inflows and outflows from the hotel business (e.g. receipts from sales revenue, salaries paid during the year etc), but interest income on a bank deposit shall not be classified as such (i.e. the hotel's interest income shall be presented in investing activities). In case of a steel plant, any inflows and outflows pertaining to steel production will be cash from operating activity but the sale of a mini steel division will classify as an investing / divesting activity and will be shown as an inflow from investing activities.
Normally, the profit before tax (PBT) as presented in the income statement is used as a starting point to calculate the cash flows from operating activities. Following adjustments are made to the profit before tax to arrive at the actual and effective cash flow generated from operations:
- Elimination of non cash expenses (e.g. depreciation, amortization, impairment losses, bad debts written off, etc)
- Removal of expenses to be classified elsewhere in the cash flow statement (e.g. interest expense should be classified under financing activities)
- Elimination of non cash income (e.g. gain on revaluation of investments). These items don’t impact the cash position of the company.
- Removal of income to be presented elsewhere in the cash flow statement e.g. dividend income and interest income should be classified under investing activities. Of course, in case of dividend paid out it will be classified under financing activities.
- Working capital changes (e.g. an increase in trade receivables must be deducted to arrive at sales revenue that actually resulted in cash inflow during the period). That is because change in stock is just a notional valuation and does not result in any tangible cash flow for the business.
Cash flow to / from Investing Activities
Cash flow from investing activities includes the movement in cash flow as a result of the purchase and sale of assets other than those which the entity primarily trades in (e.g. inventory). In case of a manufacturer of cars, proceeds from the sale of factory plant shall be classified as cash flow from investing activities whereas the cash inflow from the sale of cars shall be presented under operating activities. Cash flow from investing consists primarily of:
- Cash spent on the purchase of investments and other fixed assets
- Cash inflow from income from investments in the form of dividends or interest
- Cash inflow from disposal of investments and fixed assets
Cash flow from financing activities
This focuses on how the balance sheet is financed; whether through debt or equity. Cash flow from financing activities includes the movement in cash flow resulting from changes in debt and equity and includes the following:
- Proceeds from IPO / FPO / OFS / rights or any other issuance of shares, debentures and term loans from banks or financial institutions
- Cash outflow expended to service the source of financing and it includes interest on debentures, dividends on preference shares, dividend on equity shares etc
- Cash outflow on the repurchase of share capital and repayment of debentures & loans. Share buybacks fall under this category.
In a nutshell, the cash flow statement captures the movement in cash under the 3 heads as classified above.
Why is the cash flow statement so important?
For investor and for analysts, the statement of cash flows provides important insights about liquidity and solvency of a company which are vital for survival and growth. It also enables analysts to use the information about historic cash flows to form projections of future cash flows on which to base their economic decisions. The cash flow statement basically summarizes the key changes in financial position during a period and becomes an important source of information for line managers and for the top management.
It provides a quick insight into how the cash is going and how it is coming and whether there are some serious mismatch trends that are visible. For example, increase in capital expenditure and development costs may indicate a higher increase in future revenue streams whereas a trend of excessive investment in short term investments may suggest lack of long term investment opportunities. For an investor or an analyst, the cash flow statement helps them to separate the wheat from the chaff. Most income statement parameters can be manipulated but the cash flow statement is hard to manipulate. Also when the income statement is ratified by the cash flow statement it is able to point out cases where the numbers don’t seem to add up.
Beyond The Financial Statements – 4 Key Aspects to Watch Out
It is said that while financials are critical, the real problems arise from areas outside the financial statements. Here are four items outside the financial statements to look out for.
Contingent Liabilities
Contingent liabilities are liabilities that may be incurred by an entity depending on the outcome of an uncertain future event. Classic examples of a contingent liability are court cases, derivative exposures etc. In such cases, the liability is not yet recorded but it has the potential to become a major problem in the coming years. In the last 15 years, especially after the Enron collapse in 2001, the reporting and evaluation of contingent liabilities has assumed a lot of significance.
One of the common forms of contingent liabilities apart from legal disputes and derivative exposures is guarantees given by the company for loans. This becomes a contingent liability because if the borrower defaults on the loan then the liability vests on the company. These are normally outside the financial statements but are an important part of company analysis.
Off-Balance Sheet Items
Off balance sheet items are significant items that are not shown on the balance sheet to underlay their impact on ratios. To that extent, contingent liabilities are also an example of off balance sheet items. For example, operating lease, which is an alternative way of financing an asset is an off-balance sheet item. If a company has entered into a derivative contract to trade or hedge; it is also an off balance sheet item.
Accounting Policies
Quite often it is possible to inflate or deflate profits by changing the method of charge depreciation or the method of valuing inventories (FIFO versus LIFO). For example, for depreciation, companies may choose between straight line method of depreciation and the written down value method of depreciation. Such shifts are perfectly allowed. If a company is continuously changing its accounting policies, analysts need to be careful.
Notes to Accounts
Notes to Accounts provide detailed information on the items covered in the financial statements. Information in the notes include the accounting policies followed, the method for estimating the value of the assets in the balance sheet, basis for classification of assets, valuation of investments, method for recognizing revenues and booking costs, foreign currency translation, changes if any in accounting policies etc.
Analysis of Ratios
While ratios are a separate item to be dealt with, here is a quick rundown on some key ratios that come from the financial statements.
Profitability Ratios
- Gross Profit Rate = Gross Profit ÷ Net Sales
- Return on Sales = Net Income ÷ Net Sales
- Return on Assets = Net Income ÷ Average Total Assets
- Return on Stockholders' Equity = Net Income ÷ Average Stockholders' Equity
Liquidity Ratios
- Current Ratio = Current Assets ÷ Current Liabilities
- Acid Test Ratio = Quick Assets ÷ Current Liabilities
- Cash Ratio = ( Cash + Marketable Securities ) ÷ Current Liabilities
Management Efficiency Ratios
- Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable
- Days Sales Outstanding = 360 Days ÷ Receivable Turnover
- Inventory Turnover = Cost of Sales ÷ Average Inventory
- Days Inventory Outstanding = 360 Days ÷ Inventory Turnover
- Accounts Payable Turnover = Net Credit Purchases ÷ Ave. Accounts Payable
- Days Payable Outstanding = 360 Days ÷ Accounts Payable Turnover