5 Simple Steps to Analyse Operating Performance of Companies _ Vijay Malik.pdf

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March28,2015

5SimpleStepstoAnalyseOperatingPerformanceofCompanies

Analyzing operating performance of any company is a critical step before taking any investment related decisionaboutanycompany.Ittellsaninvestorwhetheranycompanyisimprovingitsactivitiesyearonyearandshouldbeapotentialinvestmentcandidateoronthecontrary,itsperformanceisdeterioratingwithtimeandanyinvestmentinitsstockshouldbeavoided.

Ithankoneofthereadersofthewebsite,SatyaPrakash,foraskingcertainqueries,whichledtotheideaofwritingthisarticlecontainingtheframeworkofanalysisIuseforassessingoperatingperformanceofcompanies.

Past operating performance becomes critical, as it is the outcome of all the business strength (Moat) andintellectualpower(Management)anycompanyhas.Ifacompanyhasbeentoutedastheonewithhugemoat,however,doesnotdeliver in termsofoperatingperformance, thenan investorshouldbequitewaryof relyingonsuch claims. On the contrary, some hidden gems in themarkets, which never get media attention, have strongbusinessadvantagesandmanagementsandkeeponshowingimprovedoperatingperformanceyearonyear.Ifaninvestorisabletoanalyseandjudgetheoperatingperformanceofacompanyoveryears,thenshecaneasilyfindoutstronginvestmentworthystocksthatcangeneratesignificantwealthforheroverlongperiods.

Pastfinancialperformancedataispresentedbythecompaniesintheirannualreports.Untilnow,itusedtobeverycumbersome for an investor to collect such data, as it involved punching the data from annual reports into aspreadsheetandanalyzingitunderdifferentratio/parameters.

However, currently, investors have different freely available tools, which provide the read to consume data inspreadsheet format about different companies. An investor can download such data from these online sources,analyse it using certain parameters, and come to know whether any company has been showingimproved/stagnating/deterioratingoperatingperformanceovertheyears.

In Indianstockmarkets, suchdata forpast10years isprovidedbyportals likeScreener.inMorningstar.inOther foreign markets would have similar portals where an investor can get the financial performance data ofcompaniesandanalyseit.

Asimpleframeworkofanalyzingoperatingperformancetakesitoriginationfromthebasicpremisesoftheobjectiveofexistenceofanycompany,whichistogrowthewealthofitsshareholders.Thispremisecanbebrokendownintosimplersteps,whichacompanyneedstofollowoveritslifetime:

1. Companiesneedtogrow,2. Maintainorimproveprofitability,3. Operateefficiently,4. Convertprofitsintofreecashand5. Usethisfreecashtofundfuturegrowth.

Letusnowunderstandthetoolsusedtoanalysetheperformanceofanycompanyovertheseparameters.Ideally,aninvestorshouldanalysethedataforpast10years,whichiseasilyavailableonabovementionedportals.

Itisexpectedthateverycompany,whichwouldgenerategoodreturnsforitsshareholders,wouldgrowitsbusinessandproduceincreasedsalesyearonyear.

It can be measured through the compounded annual sales growth (CAGR) of sales over the yearsinvestorshouldobservethatsuchsalesgrowthisconsistentyearonyear,ratherthanabnormalspikeinoneortwoyears,whichhidetheotherwisepoorperformanceofmultipleyears.

Profitabilityismeasuredbyoperatingprofitmargins(OPM)andnetprofitmargins(NPM)ofanycompany

OperatingProfit is the residual profit after deducting the cost of rawmaterial, employee costs, sales& generalexpensesetc.fromthesalesrevenueofanyyear.Itshowstheprofitabilityofanycompanybeforethechargesforcapitalstructure(interestexpensefordebtraised)andcapitalintensity(depreciation)ofanybusinessor taxesaredeductedfromsalesrevenue.OPMmeasurestheprofitabilitypurelyfromcoreoperationsofanycompanywithout

A)CompaniesNeedtoGrow(SalesGrowth):

B)MaintainorImproveProfitability:

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factoringinthenonoperatingincomelikeinterestincomeordividendincome.

NetProfitisthefinalamountremaininginthehandsofequityshareholdersafterallpossibleexpenseslikeinterest,depreciation, taxes etc. are deducted from total income (including operating sales revenue and nonoperatingincome).Thisamountisavailabletothecompanyforeitherdistributingtoshareholderslikedividendsorinvestingincompanysoperationsasshareholdersincrementalcontributioninthebusiness.

AnalysisofbothOPMandNPMareimportantwhileanalyzingoperatingperformanceofanycompany.Companiesshouldshowstableorimprovingprofitabilityyearonyear.Ifprofitabilityisnotstable,itfluctuateswildlyyearonyearorisdecliningconsistently,thenaninvestormustdelvedeeperintounderstandingthebusinessdynamicsofthecompany. If she is not able to find any satisfactory answer to such undesirable patterns in profitability, then sheshouldavoidthiscompanyandlookforotherinvestingopportunities.

YoushouldreadtheanalysisofHondaSIELPowerProductsLimited,whichpresentsacaseofincreasinggrowthatthecostofprofitability:

Q&AAnalysis:HondaSIELPowerProductsLimited

(Image:financialperformanceofHondaSIELPowerProductsLimited)

There are many tools, which an investor can use to measure operating efficiency. However, I believe that thefollowingthreetoolswouldprovideanyinvestorwithsimpleeasytoapplyparameter,whichwouldhelphergettherightconclusioninalmostallthecases:

Inventoryturnoverratio(ITR)measurestheefficiencywithwhichacompanyusesitsinventory (rawmaterial,workinprogressandfinishedgoods)toconvertitintofinalsales.Itismeasuredbytheformula:

SalesInventoryturnoverratio:__________________________________________________Averageinventoryatstartandendoftheyear

Higherratioindicatesthatacompanyisabletorotateitsinventoryfasteranditscapitalisnotstuckininventory.

Ideally, Inventory turnover ratio should be stable or increase with improving performance. DecliningInventory turnover ratioshould raise the flagsandan investorshoulddelvedeeper tounderstand itscause. If theinvestor is not satisfiedwith the outcome then she should avoid investment in such company and look for otheropportunities.

TheabovementionedcaseofHondaSIELPowerProductsLimitedalsorepresentsacaseofdeclininginventoryturnover.

Days of receivables outstanding or Receivables Days broadly reflects the average number of days in whichcustomersofanycompanypaytheirduestothecompany.ReceivablesDaysarecalculatedas:

Averagetrade/accountreceivables(debtors)atstartandendoftheyear*365ReceivableDays:___________________________________________________________________Sales

Ideally,theReceivablesDaysshouldbestableordeclining.Ifitwereincreasing,thenitwouldamountthatthecompanyisnotabletorealizeitsduesfromcustomersintime.Thiswouldamounttocompanyusingmoreofbankfunding (working capital funding) to meet its daytoday cash requirements. This would lead to higher interestexpenseandlowerprofitability.

The abovementioned case of Honda SIEL Power Products Limited also represents a case of increasing

C)OperateEfficiently:

1)InventoryTurnoverRatio:

2)DaysofReceivablesOutstanding:

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5/21/2015 5SimpleStepstoAnalyseOperatingPerformanceofCompanies|VijayMalik

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ReceivablesDays.

Assetturnoverratiorepresentstheefficiencywithwhichacompanyutilizesitsassetstoproducesgoodsforsales.Differentkindsofasset turnover ratiosare invogue forassessing theefficiencyofcapitaldeploymentbyacompany.

MostcommonoftheseratiosareTotalAssetTurnoverRatioandFixedAssetTurnoverRatio.IpreferusingFixed Asset Turnover Ratio as it indicates the usage pattern of operative productive assets like plants andmachineryandexcludesassetsheldinformofinvestmentsinthirdparties,cashetc.

FixedAssetTurnoverRatioiscalculatedas:

SalesFixedAssetsTurnoverRatio:_________________________________________Netfixedassetsattheendoftheyear

Many investors use the average of net fixed assets at the start and end of the year for arriving at FixedAssetsTurnover Ratio, which is also right. An investor should do fine if she uses any of these formulas and uses itconsistentlytocompareresultsovertheyears.

Financialanalysisallowssufficientleewaytoinvestorstoexperimentwithdifferentratioswithtweakingtheexistingratios or creating altogether new ones, if an investor believes that it might give a new insight while analyzing acompany.

Fixed Assets Turnover Ratio indicates how efficiency a company is using its assets. A Fixed AssetsTurnover Ratio of two indicates that every incremental investment of INR 1 in its plants and machinery wouldincrease itssalesbyINR2.AhigherFixedAssetsTurnoverRatio isalwayspreferableand indicatesgooduseofshareholdersfunds.

Ideally,FixedAssetsTurnoverRatioshouldbestableorincreasewithimprovingperformance.DecliningFixedAssetsTurnoverRatioshould raise the flagsandan investor shoulddelvedeeper tounderstand its cause. If theinvestor isnotsatisfiedwith theoutcome thensheshouldavoid investment insuchacompanyand look forotheropportunities.

AninvestormustreadthecaseofAmtekIndiaLimiteddiscussedinthisarticle.AmtekIndiaLimitedpresentsatypicalcaseofverylowassetturnoverinahighlycapitalintensivebusiness.AmtekIndiaLimitedislosingbecauseofverylow asset turnover, as the business consumes far more cash than it produces. This has led to the companyincreasingrelyingondebttomeetitscashrequirementsandasaresult,itsdebthasincreasedwhopping33timesinlast10years.Youmayreadthecompleteanalysishere:

Q&AAnalysis:AmtekIndiaLimited

(Image:financialperformanceofAmtekIndiaLimited)

Convertingprofitsintofreecashisveryimportantforanycompanyasitisthecash,whichisgoingtoaddvaluetotheshareholders.Ithasbeenprovedmultipletimesthatcompaniesgobankruptnotwhentheydonothaveassets,butwhentheyrunoutofcash.

Aninvestorshouldcomparecumulativeprofitaftertax(PAT)oflast10yearswiththecumulativecashflowfromoperations(CFO)forthesameperiodtoassesswhetherthecompanyisabletoconvert itsprofitsintofreecash.

3)AssetTurnoverRatio:

D)ConvertProfitsintoFreeCash:

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5/21/2015 5SimpleStepstoAnalyseOperatingPerformanceofCompanies|VijayMalik

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CFO is derived fromPATafter adjustingPAT for nonoperatingexpenses like interest, depreciationandworkingcapitalchanges.

Ifacompanymanagesitsworkingcapitalwell,thenideally,itsCFOshouldbehigherthanPATbecauseoftheimpact from adding back interest and depreciation. Therefore, when we notice that over 10 years CFO of acompanyislessthanthecumulativePATithasdeclared,thenitshouldraiseflags.Itwouldindicatethatthemoneyisbeingstuckinworkingcapital.

Moneyismostcommonlystuckinworkingcapital intheformofunrealizedreceivables fromcustomers,which isindicatedbyincreasingreceivablesdaysorinformonincreasinginventorylevels,whichisindicatedbydecreasinginventoryturnoverratio.

Iftheprofitsarestuckinworkingcapitalandnotavailableasfreecash,itwouldreducethecashavailableforrunningdaytodayoperationslikepaymenttovendors,salariestoemployees,interest&principalpaymentsonbankloansandcapitalexpenditurefornewplants.Insuchascenario,thecompanywouldhavetorelyonothersourcesofcashlikeequityordebttofunditscashrequirements.Thiswouldleadtoeitherequitydilution,therebyreducingstakeofexistingshareholdersorincreasingdebtlevels,whichwouldreduceprofitabilitybyhigherinterestcostsandincreasetheriskofbankruptcyincaseoftougheconomicscenarios.

Therefore,conversionofprofitsintocashisnecessaryforanycompanytosurviveoverlongperiods.Ifaninvestorfinds that a company is not able to do so, then she should study it in depth and in absence of any satisfactoryexplanation,sheshouldavoidinvestinginsuchacompanyandlookforotheropportunities.

TheabovementionedcaseofHondaSIELPowerProductsLimitedalsorepresentsacaseofcompany,whichisnotabletoconvertitsprofitsintofreecash.

An investor should always keep an eye on sources of funds that a company uses for its expansion plans oracquisitions. Ideally, a company should use the cashproduced from its operations to invest in itself andproducefurtherreturnsforitsshareholders.

Ifan investornotices that thecompany is increasingly reliesondebt to fund itsgrowth, then it shouldserveasacautionary sign. The spiraling debt might be due to nonconversion of profits into cash, which can beidentifiedby the toolsdiscussedaboveordue tooverambitiousmanagement,which isexpanding faster thancompanysresourcespermit.Boththescenariosarenotgoodforshareholders.

Therefore,increasingdebtlevelsshouldalwayssignalwarningtoinvestorsirrespectiveoftheindustryinwhichthecompanyoperates. Investorsshouldfocusonfindinglowornildebtcompaniesasdebtfreecompaniescannotgobankrupt.

The abovementioned case of Amtek India Limited also represents a case of company, which has beenincreasinglyrelyingondebttofunditscashrequirementsandhasseenitsdebtlevelsspiraling.

Thepremiseofgrowthwithsustainedprofitability,improvingoperatingefficiency,conversionofprofitsintocashandthenusingthiscashforfuturegrowth,remainsthesameforallbusinesses.

Therecanbemanyotheraspectstoaccessbusinessperformancehowever,Ibelievethatifaninvestortrackstheperformanceofanycompanyonthesefiveaspectsdiscussedabove,thenshewouldbeabletogaugethebusinessperformance of almost all the companies. She can separate out the good performers frompoor ones andmakebetterinformedinvestmentdecisions.

Differentinvestorsbelievethatcompaniesinoneindustrywouldhavedifferentlevelsofratios(sayprofitabilityorD/Eratio)thancompaniesinotherindustriesandaninvestorshouldgivealittleleewaywhilecomparingtwocompaniesofdifferentsectors.However,ifaninvestoranalysesbusinessperformanceofonecompanyoverpast,thenthetrendofchange in itsratioswhencomparedwithpreviousyearswould indicate,whethercompany isshowing improvedbusinessperformanceornot.

Forexample,an infracompanymighthavehigherdebt thanaPharmacompany.However, if thedebt levelwereincreasing year on yearwithout associated increase in salesandnetworth, then itwould indicatepoor businessperformanceforbothinfraandPharmacompanies.

Therefore,Ibelievethatifaninvestormakesachecklistoftestingthepastperformanceofallthecompaniespresentingthemselvesaspotentialinvestmentopportunities,ontheparametersdiscussedinthearticle,thenshewouldbeabletosegregategoodperformingcompaniesfrompooronesandmakegoodinvestmentdecisions.Letussummarizetheparameterstoprovideareadychecklist:

1. SalesGrowth:consistentsalesgrowth(CAGR)yearonyear,withoutoccasionalspikes.2. StableorImprovingProfitability:

OperatingProfitMargins(OPM)and

NetProfitabilityMargins(NPM)

3. StableorImprovingOperatingEfficiency:

E)UsingFreeCashtoFundFutureGrowth:

Conclusion

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Dr.VijayMalikADoctorturnedBanker.Anavidtravelerandabiker.CurrentlyworksataleadingIndianprivatesectorbank.HasdoneMBA(IIFTDelhi),CFA(USA)andFRM(USA).Activeinequitymarketssince2006.

InventoryTurnoverRatio,

DaysofReceivablesOutstanding(ReceivablesDays)and

FixedAssetTurnoverRatio

4. ConversionofProfitsintoCash:CumulativeCFOshouldbehigherthanCumulativePAT5. UsingFreeCashtofundFutureGrowth:Nospiralingdebtlevels.

Iwouldliketoknowaboutyourapproachofanalyzingtheoperatingperformanceofcompanies.Whatresourcesdoyouuseforgaininginsightsintocompaniesperformance?Howhasbeenyourexperiencewiththoseresources?Yourinputscanbeofhelptotheauthorandthereadersalike.Youmayprovideyourinputsinthecommentsbeloworcontactmehere.

YoumayliketheblogsFacebookPage,subscribebyemail,followtheRSSfeedoronTwittersothatyouwouldimmediatelygettoknowwhennewarticlesarepublishedonthewebsite.

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KulbirLamba 2monthsagoHiSir,

Seriesofyourarticleshasgivenagreatinsightforanalyzingthestocksalongwithavailablesourcesforfurtherreading..thanksalotforthat.

Iwouldliketohaveyourviewsonastock,whichfulfillsmostoftheparametersforbeingagoodinvestmentlikeROCE/OPM/NPM/Salesgrowthetcetc..butthestockhasappreciatedapprox.1012timesinlastoneyear,shouldtheinvestorconsideritforinvestment,becauseitseemsthat1012timesappreciationhasleftlittlescopefornearfuture(23Years)gains..

RegardsKSLamba

VijayMalik 2monthsagoMod >KulbirLambaHiKulbir,

Thanksforwritingtome!Iamhappythatyoufoundthearticleuseful.

Thepasthistoryofpriceriseorfallisnotrelevanttillthetimeastockisavailableatreasonablepriceswhencomparedtoitsfundamentalstrengths.Stockpricesdonothaveanyceiling.

regards,

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regards,Vijay

Reply

Tulsighimire 2monthsagoDR.pleasecanyoutellusthechecklisttobeforetoinvestinanycompanyregardingalltechnicalanalysis........weallbegratefultoyousirplz,,,,,

Reply

VijayMalik 2monthsagoMod >TulsighimireHiTulsi,

Thanksforwritingtome!

Iusedtofollowtechnicalanalysisearlier,however,lateronrealizedthatIammoresuitedtofundamentalanalysis.Ihavewrittenaboutmyexperienceinthearticle:

"WhyIlefttechnicalanalysisandneverreturnedtoit"

http://www.drvijaymalik.com/20...

Youmayreadthebooks,Ihadreadfortechnicalanalysishere:

http://www.drvijaymalik.com/20...

regards,Vijay

Reply

Tulsighimire 2monthsago>VijayMalikThannkyousir.....

Reply

AyyubMohammad 2monthsagoHiVijay,

Articleveryclearandgoodforunderstandingwithexamples.Lookslike"DaysofReceivablesOutstanding"calculationformulathereistypoerrormentionedas"Inventoryturnoverratio:".

Whatisyoursourcefor"assetsturnover,receivabledays,Inventoryturnoverandnetfixedassets"?I'minlearningstageanalyzingdifferentcompaniesandgoingthroughannualreports.ItwouldreallyhelpfulifIcangettheabovesourceofdata.

regardsAyyub

Reply

VijayMalik 2monthsagoMod >AyyubMohammadHiAyyub,

Manythanksforyourfeedback!

Ihaverectifiedtheerrorhighlightedbyyou.

Thedatahasbeensourcedfromscreener.inYoumayusethe"exporttoexcel"featureofscreenertocustomizethedata.

regards,Vijay

1

Reply

RajShah amonthago>VijayMalikfounditthanks

Reply

RajShah amonthago>VijayMaliksir,cannotfindxporttoexcel'featureonscreener.in.Pleasehelp

Reply

Hafizul 2monthsagoHelloVijayji.....Thanksalotforasuchagoodanalysis....Ihaveonerequestthough.....couldyoupleaseanalyzeNeoCorpinternationalintheQ&AsectionthesamewayyouhavedoneforWaterbase?Itwillbeveryhelpful.....Thanksinadvance!!!GodBlessU!!!!!!!!!

VijayMalik 2monthsagoMod >HafizulThanksforwritingtome!

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Iwouldbehappytoprovidemyviewsonthestocksmentionedbyyou.However,Iwouldrequestyoutopleaseshareyouranalysisofthesestocksandthereasonsthatmakeyoubelievethatthesestocksshouldbeconsideredforanalysis.

Youmayusethefollowingstepstoanalysethecompany:

"Howtododetailedanalysisofacompany?"

http://www.drvijaymalik.com/20...

regards,Vijay

Reply

Hafizul 2monthsago

seemore

>VijayMalik

HelloVijayji,Thanksalotforreplyingandtheadvicetogothroughthearticlesfirst....Ihavegonethroughthemandfoundthemextremelywellwrittenandexplainedclearly......andalsoexplainedwithgoodexampleofrealcompanies.....Thanksalotandappreciateallyoureffortyouhaveputontowriteallthesegoodinformation......RegardingNeoCorp...thoughitfailsattheconditionyouhavementionedthatpromoterholdingshouldbeminimum51%(Neopromoterholdingisonly24.07%)butthenalsoIaminterestedinitas:1)Promotershaveboughtthesharesfromopenmarketandincreasedtheirstakefrom19to24%inlastfewquartersandalsopledgedshares%camedowninlastfewquarters.2)Companyhasshowntremendousrevenuegrowth(5yearCAGR43%),netprofitgrowth(5year32%)andwithnewlyacquiredIPCltd,therevenueandnetprofitisallsetincreasefurther.ThisisthemainreasonwhyIaminterestedinthis.3)ConsolidatedP/Eisonly2.5whichisverymuchcheaper.4)IhavegonethroughtheannualreportaswellandfoundtheirbusinessprospectbrighterwiththeareaofTechnicalTextilesisgoingthegrowgloballyandNeoishavinggoodshareinthisareawithgoodexports.HowevertheOPN,NPM,ROEallaredecreasinginrecenttimes,anddebtisalsogoingupaslast5yearscumulativeCFOisonly66cr..whereasthenetprofitis75cr....howeverlast

Reply

VijayMalik amonthagoMod >HafizulHiHafiz,

Thanksforwritingtome!

Youmayreadmyviewsonthecompanyinthefollowingarticle:

http://www.drvijaymalik.com/20...

Regards,Vijay

Reply

DebasishHazra 2monthsagoPE/HIstorical5yearPEisgoodforMOATcompanyaswellasforMICROCAPcompanywithgoodfundamentals

Formoatcompanies,ifitissellingincheapvaluation,Example(ITC)comparingwithotherFMCGCompany.Thoughpeoplearediscountingitforlowprofitfortobaccobusiness.ThatswhythemanagementisplanningforfutureCapexprojectsonotherFMCGproducts.Weneedtostudyitproperly.

ForMICRO/smallCAP(DebasishHazraHiDebasish,

Thanksforyourinputs!

Pleaseprovideinputsonotherarticlesaswell!

regards,Vijay

DebasishHazra 2monthsagoSir,Iwanttoaddsomemorethings.

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Sir,Iwanttoaddsomemorethings.1>Averagereturnoncapitalemployedover3/5/7years

2>AltmanZscoreandcomparingitwithitspeers.

3>Piotroskiscore4>DaysPayableovertheyearsIthinkifDaysPayableareincreasing,Itmeansthecompanyisdelayingpayments,sothecompanymaynotgetthebestdealsfromitsVendors/Suppliers.Itmaydelaypaymentstoworkers,AlowPayabledays,comparetoindustryavg,meanstheWorkersandVendorsmustbehappy,andthatcreatesanadvantageasP.PhishersaysthatworkersandSuppliersmustbehappy.andquickpaymentsisoneofthemIthink.

5>AndOnvaluationPart,PE/IndustryavgPEisnecessary,tolookatifagoodcompanyissellingcheapcomparetoitspeers.

AndPE/HIstorical5yearavgPEisalsogood,(

Reply

garry003 2monthsago>DebasishHazraHiDebasishjiPlzadvicemeimlongterminvestorsoplzsomegoodstockrecommendationfromyoururpointofviewtocreatemultifodstockfromhereifyousuggest,longtermis10to15yearmonthlysaveupto15k,age32,liability15lac@4%

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VijayMalik 2monthsagoMod >DebasishHazraHiDebasish,

Thanksforyourinputs!

regards,Vijay

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