Financial analysis and financial terms
The world of finance can seem overwhelming, filled with terms (or “jargons”) that appear intimidating and complex. However, understanding these key concepts is essential to evaluating the financial health of a company.
The stock market tends to reward companies with high growth rates or those showing significant improvements in financial metrics with increased valuations and stock prices. As investors looking to benefit from such upward price movements, it’s crucial to identify these indicators of improvement in a straightforward manner.
In this post, we will cover:
Our approach to financial analysis.
Clear explanations of financial terms that are frequently used in our analyses.
What We Look For in Financial Analysis
A track record of consistent growth over multiple years.
High growth rates in metrics like sales, profits, and EPS.
Under-valuation compared to industry peers.
Relatively higher growth in sales and profits compared to peers.
Turnaround signs in sales or profit growth.
Note: No company is perfect, so not all of the above criteria need to be met for us to consider an investment.
Companies We Avoid
Those that show consistent decline in sales or profits with no signs of a turnaround.
Companies reporting net losses over multiple periods without any indication of recovery.
Businesses with low growth rates and/or lack of ambition.
Companies with very high debt relative to their business model. Excessive debt is one of the leading causes of business failures and bankruptcies.
Firms with consistently high negative cash flow.
Explaining financial terms
Keeping the above approach in mind, sharing a list of terms we typically look at and their simple explanation -
General Terms
FY (Financial Year):
A 12-month period used for accounting purposes, differing from the calendar year. For example, FY23 refers to the financial year starting from April 1, 2022, to March 31, 2023.
Q1 - Q4 (Quarter 1 - Quarter 4):
Represents the four quarters of a fiscal year. For example, Q1 for a company like Reliance Industries Ltd. would be April-June, Q2 would be July-September, and so on.
Company Overview Section
Market Capitalization (Market Cap):
The total market value of a company’s outstanding shares, calculated by multiplying the current stock price by the number of outstanding shares. Example: If Reliance Industries Ltd. has 6.34 billion shares and a share price of ₹2,300, its market cap would be ₹14.58 trillion.
Stock P/E (Price to Earnings Ratio):
The ratio of a company’s current share price to its earnings per share (EPS). It indicates how much investors are willing to pay per rupee of earnings. Example: If Reliance Industries Ltd. has an EPS of ₹100 and a share price of ₹2,300, its P/E ratio would be 23.
Price to Book Value (PBV):
A valuation ratio comparing the market value of a company to its book value. It shows how much investors are willing to pay for each rupee of book value. A PBV below 1 indicates that a company’s market value is less than its book value.
Return on Capital Employed (ROCE):
A measure of a company’s profitability and the efficiency with which its capital is employed. Calculated as EBIT (Earnings Before Interest and Tax) divided by capital employed. It shows how much profit is generated per rupee of capital employed. Example: If Reliance Industries Ltd. has EBIT of ₹100 billion and capital employed of ₹500 billion, its ROCE is 20%.
Debt-to-Equity Ratio:
Indicates the proportion of debt used to finance a company’s assets relative to equity. A ratio of 1 means equal amounts of debt and equity. Lower ratios are generally preferred as they indicate financial stability.
Promoter Holding:
The percentage of shares held by the promoters of the company. High promoter holding often suggests confidence in the business, while low or declining promoter holding could indicate lack of faith.
Pledged Percentage:
The percentage of promoter shares pledged as collateral for loans. A high pledged percentage is a risk factor because, if the share price falls, promoters might be forced to sell their holdings.
Quarterly and Annual Results Section
Sales (or Revenue):
The total amount generated from selling goods or services before deducting any expenses. For example, if Reliance Industries Ltd. sells products worth ₹1 trillion in a quarter, that amount would be its sales or revenue for that period.
Operating Profit and OPM (Operating Profit Margin):
Operating profit is the profit from core operations, excluding other income and interest. OPM is calculated as (Operating Profit / Sales) x 100, indicating how much profit the company makes on each rupee of sales.
Other Income:
Includes non-core earnings like dividends, interest, and gains from asset sales. It is separate from the operating profit and can significantly impact the net profit.
Interest:
The cost incurred on borrowed funds. A high-interest expense relative to operating profit indicates high debt levels.
Profit Before Tax (PBT):
Calculated as operating profit plus other income minus interest. It reflects the profit a company generates before accounting for tax expenses.
Net Profit (or Profit After Tax, PAT):
The profit remaining after deducting all expenses, including taxes, from total revenue. PAT shows the actual profitability of a company. For example, if Reliance Industries Ltd. has revenue of ₹1 trillion, expenses of ₹900 billion, and tax of ₹30 billion, its PAT would be ₹70 billion.
Earnings Per Share (EPS):
Indicates the profit attributable to each outstanding share, calculated as Net Profit divided by the number of shares. It is a key measure for evaluating profitability on a per-share basis. If Reliance Industries Ltd. has a PAT of ₹70 billion and 6.34 billion shares, its EPS would be ₹11.
Note for finance sector companies (Banks and NBFCs)
We ignore certain metrics like debt-to-equity and other income. The only important metrics to observe is net-profit and EPS.
This precise approach used in financial analysis along with the understanding of the essential terms provides a clearer understanding of a company’s performance and financial health.