Fundamental analysis is all about analyzing the financial statements of the company to understand the future growth and expected returns from an investment. Analyzing fundamental of a company is vital for a successful long term investment. While fundamental analysis is a great way to understand the business, there are many fine lines in the financial statements of a company that are hard to read, but can make shocking revelations about the company’s actual performance.This is where financial ratios can be very useful in understanding the real performance of a company.
What are financial ratios:
Financial ratios are company’s financial statements expressed in percentage or per share basis(for example Net Profit Margins is expressed in percentage terms while Earnings per share is expressed in per share basis)
Financial ratios are generally used for comparison purpose among peer companies. However, if used intelligently, financial ratios can reveal a lot of hidden truths about a company’s financial performance that otherwise, may not be revealed.
So let us look at major financial ratios you must use, what they mean and how they can do a better job at revealing the truths about financial performance of the company.
Earning Per share(EPS):
Earning Per Share or EPS is a ratio used to measure profitability of the company. Earnings per share reveals how much a company earns against each outstanding share of the company. The formula for calculating EPS is by dividing Net Profit by total number of outstanding shares.
To understand how EPS is a better earning measure than Net Profit, consider this example.
A company X is posting good net profit numbers for the past 5 years, which are as follows:
As you can see in the above example, company is reporting increasing profit every year, which looks great as rising profits are indication of strong underlying business. But before you reach a conclusion, let us analyze how much the company is making on EPS basis.
As you can see from the image above, despite rising profits, the Earnings Per Share of the company is going down. The reason behind it is that, in order to make higher profits each year, company has to raise more capital by selling its shares (the reason why number of outstanding shares are rising), which means, the owners of the company are diluting their shareholding in the company.
Clearly, the company is not a great long term investment as it’s business needs to raise money from external sources to increase its profits. Once the company runs out of capacity to raise capital, the profits will start to decline, ultimately pushing company into losses.
Using EPS for comparing financial performance of two companies :
EPS can also be used to compare two companies in the same sector and find which one is a better investment among the two. To understand how, let us take an example.
Imagine two companies Company X and Company Y both working in the same sector. Company X earns a Net Profit of Rs. 100 Crores, while Company Y earns a Net Profit of Rs. 200 crores.
At first, it looks like Company Y is a better investment compared to Company X as former is making higher profits compared to latter. But on comparing the EPS of both the companies, you will find that Company Y, despite having higher profits has lower EPS.
That is because while company X has Rs. 100 crore of share capital, Company Y has 400 crore of Share Capital 4 times of what company X has.
Note: Share Capital = Face value of a share X number of outstanding shares
This means company Y is using Rs. 200 crores of shareholders capital to generate Rs. 100 Crores of profit (400/200), while Company X is able to generate same amount of profit using half the capital(100/100).
In other words, Company Y needs higher capital base to generate the same profits as Company X. This shows company Y is less efficient in utilizing shareholders fund compared to Company X. Again, EPS proves to be a useful tool to analyze and compare companies in a better way.
Net Profit Margins:
Net Profit shows you how much profit a company is making on every sale or revenue, Net Profit Margins measures the percentage of revenue left as profit after paying all the expenses.
Net Profit margins give you a clear picture of the profitability of the company and also allow you to compare two or more companies, helping you chose a better one among the available option.
To understand how Net Profit Margins can reveal the true picture about a company’s profitability, consider the following example:
Look at the table above, it shows the past 5 years of data of Revenue and Net Profit of a company. You will notice that both the Revenue and the Net Profit of the company for the past five years are continuously increasing. At first it may seem that the company is a good investment as both Revenue and Net Profit are on the rise.
But if you look at the Net Profit Margins, you will find a very different picture. While both Revenue and Net Profits of the company are increasing, The Net Profit Margins are on the decline. This shows that company is unable sustain its profitability which may be due to increasing operational expenses, increase in raw material prices, rising competition which led to a price war.
Companies with declining profit margins should be cautiously dealt with as declining margins is a sign of deteriorating profitability of a company.
If you find a company with increasing profits, do not forget to check their Net Profit Margins, if the margins are declining, find a reason behind it.
Net Profit Margins can be very crucial in decision making. A company with huge profits may have very thin profit margins, making it vulnerable to price changes, while a company with small profit may have strong profit margins, making it a great investment.
By using Net Profit Margins in your analysis you can better understand the profitability of companies and compare two or more companies to find a better investment for your portfolio.
Debt To Equity:
Every company needs money to expand its business. Broadly, there are only two ways a company may use to raise funds for expansion, first debt second equity. Raising money via equity dilution may not be easy as it requires approval from directors, shareholders, market regulators, and there is no certainty whether company will be able to raise the desired amount of funds successfully. In other words, raising money via equity dilution is a lengthy and time taking process.
Debt on the other hand is relatively easier way to raise fund for business expansion. Any company willing to raise funds for its business can approach a bank or any NBFC(Non Banking Finance Company) with its business plan and get funded easily.
Although debt financing is an easier option, it should not be overused by the companies as it has its own disadvantages. A company raising money by equity shares can distribute a part of its profit as dividends. In case it suffers a loss, company is not obligated to pay anything to its shareholders.
On the other hand, if a company is financed by debt, it has to pay its lenders (with interest) irrespective of whether they make a profit or suffer a loss. In case of loss, company may be forced to sell its assets (such as plant and machinery) to pay for its debt obligation or has to declare itself bankrupt.
It is usually believed that little debt does not harm the business and in fact, some amount of leverage is healthy for a business. As a thumb rule, a debt to equity levels below 0.5 is a favourable debt level.
To understand how debt can affect a business, let us consider two real life examples:
Two companies, JP associates and L&T work in the same sector of infrastructure development. The only difference between two companies is that while L&T managed to keep its debt level below 0.5, JP Associates, in order to fund its operations and expansion, accumulated debt 2.5x its equity.
When infrastructure sector went through tough times, L&T, being conservatively financed, managed to stay afloat even in bad times, increasing profitability from Rs. 4,910 crores in 2013 to Rs. 5,453 crores in 2017. On the other hand, JP associates, being highly leveraged, started to suffer losses as it has to service its debt despite losses. As a result, JP associates went down from a profit of Rs.500 crores in 2013, to a loss of Rs.4,361 crores in 2017.
The impact of their financial performance can be clearly seen in their stock prices. While JP associates stock price went down from a high of Rs. 89.85 per share(4 June 2014) to a current price of Rs. 20 per share(As on 9 April 2018). L&T on the other hand went up from a low of Rs.452 per share (on 23 August 2013) to current market price of Rs.1,324 and also delivered bonus shares of 1:2 to its shareholders on 13 July 2017.
Dividend per share and dividend yield:
Dividends are a part of company’s profits that a company distributes to its shareholders. Dividends are declared as a percentage of the face value of the share. For Example, if a company’s share has a face value of Rs.10 and the company declares a dividend of 100%, it means that each shareholder will get Rs.10 as dividend for each share held. Investors buy stock from stock market where shares are usually traded at a much higher price than face value. Since we pay much higher price against the dividend received, dividends as a percentage of the face value of the company do not give you the real picture of return on invested capital.
The best way to understand how much dividend you will receive against invested capital is by looking at dividend Yield.
Dividend yield is calculated by dividing the dividend per share with the market price of the share. Dividend yield of two stocks may significantly vary even if both the stocks have the same face value. To understand it in a better way let us take a simple example.
Let us take an example of two companies, company X, trading at a market price of Rs. 50 per share and company Y trading at a market price of Rs. 20 per share. The face value of both the companies is Rs.10 each and both the companies pay a dividend of Rs.5 per share.
If we compare the dividend payout of both the companies, there is no difference as both the companies pay a dividend of 50% on the face value(dividend per share/face value= 5/10).
At this point it looks like both the companies pay same amount of dividend and there is no reason to choose one over the other. But if we analyze further and compare the dividend yield of the two companies, it paints a completely different picture.
As mentioned earlier dividend yield is calculated by dividing dividend per share with the market price of the share. If we compare the dividend yield of both the companies, Company Y provides much better dividend yield of 25% (5/20)compared to company X which provides a dividend yield of 10%(5/50). Clearly, for a dividend investor, Company Y is a much better investment option compared to Company X.
In the long term, the price of a stock is determined by the financial performance of the company, and that is why it becomes important to analyze, in detail, the fundamentals of a company before making a long term investment decision. While financial statements can be a great source to understand about the overall financial performance of the company, there are certain critical areas, where financial statement fail to give accurate information about the company. By analyzing the financial ratios of the companies, and using them to compare two or more companies within the same industry will prove to be extremely helpful to make more rational and wise investment decision.