Lesson 6 – Key financial parameters that matter the most
In this lesson you will understand the important financial parameters that you will study from financial statements. You will understand their implications for stock investing decisions.
- Operating profit margin
- Net profit margin
- Debt to equity ratio
- Return on Equity
- Earnings per share
- Operating cash flow
- Free cash flow
In prior lessons you studied qualitative aspects of investing. In this lesson you will start with the quantitative aspects of stock investing.
Operating profit margin
Operating profit margin is calculated by dividing operating profit (EBITDA) by Net Sales. It a useful parameter to track for a company as it is unaffected by interest, depreciation and taxes. You will agree that operating profit can sway up or down for business reasons including selling prices, cost of raw materials, salaries and marketing costs. If you look at the last 5 or 10 years for a company, you can get a fair idea of how volatile or stable the business is and whether operating profit margin (OPM) has grown.
It is expressed as a percentage. Please refer the last lesson email and see the Supreme Industries P&L statement. Divide Profit before Interest, Tax, Depreciation and Amortisation by the Total Income and you will see that it has an OPM of 16%.
Obviously, if OPM has a rising trend for any company, it is a good sign. But don’t expect a perpetual rising trend as there will be an upper limit to OPM for a particular business. Different industries have different average OPMs. Compare the OPM of the company you are studying to its competitors.
Net profit margin
This is calculated by dividing net profit or Profit after Tax (PAT) by net sales. For Supreme Industries it works out to around 8%. Please attempt to calculate once by yourself if you have never done these calculations before.
Again, a stable, if not rising, net profit margin is usually good for shareholders.
Debt to equity ratio
You know the dangers of taking too much debt at a personal level. Companies are not immune from debt problems either.
In fact, there are so many examples from corporate India of companies which took on too much debt and got into trouble. Suzlon, Wockhardt, players in the real estate sector like DLF and Unitech are just a few of the names.
You can start using the word leverage from now on. Such companies with too much debt are highly leveraged.
The debt to equity ratio (D/E) is what you should be tracking closely to understand whether a company is taking on too much debt.
Refer the last email lesson. For Supreme Industries, add Short-term borrowings and Long-term borrowings. Let us call this total debt.
Also add Share Capital and Reserves & Surplus. This is called Net Worth.
Divide total debt by net worth. Please try calculating now.
Do you too get a value of 0.4 for Supreme Industries?
A D/E ratio greater than 1 is cause for caution. When you go higher than 1.5-2 times it usually means there is a debt problem. (exception – infrastructure companies may have high debt ratios and it is necessarily not a bad thing in this sector)
With higher debt, interest payments will eat into the operating profit. It can cause losses to the company. Cash will be eaten up by interest and principal repayments.
Such companies are delicately poised. If business is good, they will sail through fine. But they are susceptible to collapse in an economic downturn or a business down-cycle.
It is wise to stay away from such companies unless you have particularly compelling reasons to invest. If you are starting off, stick to companies with D/E lesser than 0.5. Even better, if a company has a history of not using debt, your work becomes simpler.
Return on equity
Imagine that you invested your money in a bank fixed deposit (FD). Say you put Rs. 1000 in an FD that fetches an interest rate of 8%. You get Rs. 80 every year as interest.
Now keep this in mind and consider the net worth figure in the balance sheet. To remind you again, it is calculated by adding share capital plus reserves & surplus. All this money belongs to the shareholders including the promoters and other shareholders like mutual funds, Foreign Institutional Investors (FIIs) and retail investors like you and me.
Can’t we consider this to be our capital in the company as of today?
What is our return on investment?
Well, in equity, we measure returns to shareholders like we measure returns to deposit holders in a fixed deposit. The shareholders’ return is Net profit or profit after tax.
Return on equity is PAT divided by net worth.
Return on equity (ROE) is one of the most important parameters when you study a stock.
Consider this. You can earn around 8% or so by investing in a relatively safe fixed deposit in a bank. Surely, you expect more from a business. There is risk in a business. You expect decent returns. Definitely, not as low as 8%.
The question is how much should you expect?
A safe value would be to consider companies that have a return on equity that is greater than 20%. Just not for the last year.
They should have maintained such a RoE on average for at least the last 5 years. This ensures that you don’t get swayed by one year of possibly super-normal profits.
You don’t want the company’s performance to be like a falling star that blazes in the sky for a short period but quickly disintegrates away. It should last.
Re-read Lesson 3 that talked of Sustainable Competitive Advantages. Usually such companies with moats enjoy high return on equity on a sustained basis.
Earnings per share
You might have heard this term already or its acronym, EPS, on the financial TV channels. Come results season and analysts and TV hosts talk about company results and about their EPS in the last quarterly result or annual result.
EPS can be calculated by dividing PAT by the total number of outstanding (or issued) equity shares. In Annual Reports you will see this already calculated for shareholders but it is important to know how it is arrived at.
Rising EPS is good for you. Plain and simple.
Dividends are deducted from the profit after tax amount and paid to all the shareholders. The balance is called Retained profits. This balance amount is added to existing reserves and surplus. It accumulates year after year.
Dividends are a return of cash to shareholders. This along with the capital appreciation one gets from holding a stock that rises in price, combines to give total returns to shareholder.
Operating cash flow
I explained in the last lesson about the importance of cash. Please pay attention to operating cash flow. You will find this in the cash flow statement.
At the bare minimum, a company should have a track record of healthy positive operating cash flows. If this figure is negative, see if there are temporary business reasons or if this has usually been the case in the past. Be very, very cautious if this is not positive consistently.
If the operating cash flow (OCF) is greater than PAT it is good for shareholders. PAT is an accounting measure. Cash matters most.
Free cash flow
Most companies grow with time. Growth requires fresh investments for capacity additions to existing assets or for greenfield expansions.
By now you will be guessing what I am aiming at. These activities require cash.
Where can a company get the cash from?
From financing, either by taking loans (debt) or issuing more shares and raising equity capital.
Too much debt is not good.
Fresh creation of shares implies reducing earning per share for same earnings. You might say that earnings will increase with new capacity. I say, yes, hopefully.
Always take things with a pinch of salt. What if the expansion is a flop show?
Free cash flow is Operating Cash Flow minus Capital Expenditure.
Or, it may be calculated as OCF minus Net additions to Fixed Assets.
Positive and growing free cash flow (FCF) is good for shareholders.
- Calculate free cash flow of Supreme Industries. Use the cash flow statement you see in Lesson 5.
- Calculate return on equity of Supreme Industries. Use the P&L and balance sheet from Lesson 5.
- Email me at firstname.lastname@example.org with your solution.
- Please type the answer in your email directly. Please do not send Excels and attachments.
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