Topic 3; Overview of company analysis

Company analysis is a detailed examination of a specific business entity to assess its financial health, operational performance, competitive position, and overall potential as an investment. It is a fundamental component of investment research and is crucial for making informed decisions about buying, holding, or selling stocks or other securities. Here’s an overview of the key aspects involved in company analysis:

Components of Fundamental Analysis

The scope of Fundamental Analysis is vast and it covers a lot of elements. Some of the elements are discussed below:

1. Working Capital Analysis

Working Capital Analysis reflects whether there are sufficient current assets for the current liabilities that a company has. It measures the liquidity of the company. The short-term ability to cover the short-term liabilities dictate how well-positioned the company is in the market.

2. Operating profit margin

Operating Profit margin is the ratio of Operating Income, divided by the total revenue of the firm. The ratio measures the profitability of the firm.

3. Free Cash Flow Analysis

Free Cash flow analysis measures the profitability of the firm after excluding the non-cash expenses of the income statement and including spending on equipment as well as changes in the Working Capital from the Balance Sheet. Free Cash Flow (FCF) Analysis reflects on the overall value of a company and may indicate the health of its trends.

4. Ratio Analysis

There are 8 simple ratio analysis tools to picture the overall functioning of a company and provide a reflection of where its valuation might be in the future.

The ratios are as follows:

• P/E Ratio: The Price-Earnings Ratio or the P/E is obtained by dividing the current price of a company’s share by the Earnings Per Share (EPS) of the company. It provides a clear picture of the amount of money that investors would be willing to invest in a share of a company.
• Debt-Equity Ratio: This financial ratio provides an understanding of the relative proportion of the debts that have been accrued to finance the company’s assets and the shareholders’ equity in the company. It is represented by dividing the total debt of the company by the shareholders’ equity.
• Earnings per share (EPS): EPS is the most widely used ratio as an indicator to measure a company’s profitability. It is obtained by dividing the net profit of a company by the number of outstanding shares.
• Return on Equity: Return on Equity (ROE) serves as a great instrument to measure the financial performance of a company by dividing the net income of the company by the shareholders’ equity. ROE is considered to be the return on net assets since the shareholders’ equity is obtained by taking away the debt from the company’s assets.
• Price-to-Book Value Ratio: Price-to-book value ratio gives a larger picture of the company’s current market value, as compared to its book value. It indicates how the company has performed over the years and indicates whether the company is overvalued or undervalued.
• Dividend-to-price ratio: It is a percentage used to exhibit how much a company pays out in dividends every year, as a percentage of its stock price. It is calculated by dividing the annual dividends per share by the Current share price in the market.
• Working Capital Ratio: The ability to pay off short-term liabilities (to be repaid within the next 12 months) with the current assets are often an indicator of the liquidity of the company. Working Capital Ratio is obtained by dividing the Current Liabilities by the Current Assets of the company.
• Quick Ratio: Quick ratio is almost similar to Working Capital Ratio, except for the fact that Quick Ratio considers the firm’s liquidity in terms of current assets, without considering Inventory. Hence, it gives a reflection on the ability of the firm to pay the current liabilities without having to sell their inventory.

5. Analyzing the Annual Reports of a Company

There is no better way to ascertain the financial position of a company in the market than to analyze the annual reports and look for indicators of growth or decline. One of the most useful indicators is the Profit and Loss(P/L) Statement.

A P/L statement provides a holistic view of the revenues, expenses incurred during the financial year or quarter. It indicates the company’s ability or inability to meet the expenses, while generating profit, increasing revenue, and reducing costs.

A trader or investor should always be in a position to read and analyze the P/L statement. The profit and loss statement has two distinct parts- the Revenue and the Expenses.

We obtain the total revenue by adding up the different kinds of revenues (products, services, additional operational) and taking away the excise duties paid. The various expenses are deducted from the total revenue to reach the profit before taxes.

We arrive at the Profit After Tax (PAT) after the various income taxes are deducted. Investors generally look at the PAT figure to estimate the ability of companies to generate a return on their investment. The calculation of PAT also incorporates both operating incomes, as well as income from other sources.

6. Expense Trends Analysis

Expense Trend Analysis (ETA) is a summarized report on the Expense of a company over time. A very common approach to generating an Expense Trends Analysis is to compute the change in expenses, keeping a base year and find the net change in expenses.

7. EBIT and EBITDA

Earnings before interest and taxes (EBIT) refers to the net income generated by the company before the interest and tax expenses are deducted. It gives a fair outlook on the performance of the company and its core operations, without considering tax expenses. The cost of capital structure eventually influences the profits.

The formula of EBIT is given by EBIT= Net Income + Interest Expense + Tax expense.

EBITDA, on the other hand, considers interest, taxes, depreciation and amortization as an indicator for the position of the company in terms of financial performance and earnings potential. EBITDA helps an investor ascertain the net cash flow of the company.

The formula for EBITDA is EBITDA= Net Income +Interest Expense +Tax Expenses + Depreciation + Amortization.

EBIT is generally considered to be a good indicator of how the company is performing, and EBITDA is an indicator of the spending power of the company. In the case of heavy-capital companies, EBITDA is useful, since a lot of the operating budget is eaten up by depreciation and amortization, and may give an incorrect idea of how well the company may be performing financially.

8. Understanding the Balance Sheet

The Balance Sheet is a financial statement that summarizes the assets, liabilities, equity capital of a company at a specific point in time. It reflects the balance of the company as of a given date and helps the investors get an idea for evaluating the capital structure of a company and computing the rates of return. It is the main pillar while performing fundamental analysis of a company.

9. Debtor and Creditor Analysis

Debtors are the parties who owe the company money. The amount that is owed is repaid periodically, with or without interest. Depending on the type of financial undertaking, a debtor can be termed as a borrower or issuer (in the case of bonds).

A creditor is a party that provides money, hoping for the entire amount with some interest to be paid back in the future. Creditors are generally of two types- secured and unsecured. Secured creditors provide loans to the companies only after the company pledges some sort of collateral, which can be seized if the company fails to repay the loan.

Both the creditors and the shareholders are always exposed to the residual risk of companies that they invest in. Debt tends to be a form of company that stays throughout its life, and hence successful companies try to maintain a positive relationship with the creditors and shareholders, which ensures easy and cost-effective access to both debt and equity capital.

10. Major Shareholders in the Company

As an investor, it is important to have a background check into the companies which are the top shareholders of the company they are trying to invest in. For example, Tobacco Manufacturers India Ltd and Life Insurance Corporation of India are the top investors of ITC Limited. It is important to look into the performance of these companies, which might directly affect not just the relationship between the ITC and them, but also change the capital structure of ITC.

11. Long term liabilities

It is essential to analyze the long-term liabilities to know how the company will solve the long-term solvency of the company. It reflects how the company has planned its long-term finances and acquired its immediate capital to fund the purchase of capital assets or invest in new projects.