I was thinking since quite some time to write a note on learning from classes and after a prolonged gap putting few of the key
concepts. Here it goes -
While most of us have come across terminologies like Balance
Sheet, P&L (Income) statement and Cash flow statement but we are unaware of
the underlying concept.
Balance sheet can be defined as balancing what we own and
what we owe. In accounting terminology, this can be written as
Asset = Liabilities + Share Holder Equity
Expanded version >
Fixed Asset + Investments + Current
Asset - Current Liability = Secured Loan + Unsecured Loan + Deferred Tax +
Shareholders' Equity
P&L statement is just a readable version of the
information hidden in BS and summarize the organization operations for specific
period.
Considering there are opportunities to fudge the data and
represent in favorable light there was a need of another report which entails
the cash status for a company. That’s where cash flow statement comes into
picture. This is difficult to fudge as it accounts only cash in-out (revenue/expenses)
details and can provide overview of cash position of company.
While these were key principle associated with financial
accounting, to learn about financial well-being of company one need to do
financial analysis. Common size analysis, trend analysis and DuPont analysis
offers great tool to analyze companies overall health of company in simplistic
ways.
Return on Equity (ROE) = Profit/Equity
= Return on Sales (ROS)
* Asset Turnover (ATO) * Equity Multiplier (EM or Financial Leverage)
= Profit/Sales * Sales/Asset * Asset/Equity
= (Profit/EarningBeforeTax
* EBT/EarningBeforeInterest&Tax * EBIT/Sales) * Sales/Asset * Asset/Equity
Where Profit refers to ProfitAfterTax(PAT)
Above statement can also be written in not so layman
terminology as
ROE = (Tax Burden * Investment Burden * EBIT%) * Asset Turnover
* Equity Multiplier
Management team typically looks at EBIT% and ATO. Remaining
are Financial, Treasury and Tax team handles.
Detailed chart for covering each area of dupont analysis can
be understood from the chart below –
In most of the cases it can be assumed that higher is better
except when it comes to Current Asset TO and Inventory TO which should be evaluated
in inverse thereby making them lower the better. On similar line Collection
period should be lower the better.
Profit Margin refers to operating efficiency and can be
elaborated/improved through cost ratio’s as shown in chart.
Asset turn over ratio simply means asset use efficiency which
means generating more revenue for each added asset.
Ratio analysis YOE or with peer provide a level ground to
analyze a company. This analysis holds good for most of the industry accept
banking industries.
Common Size analysis also offers a good tool to analyze
companies at basic level whereby BS, P&L and CF data are converted into
percentage format and sub-component broken down as % of top component.
In trend analysis a base year is identified and then growth
is calculated for each and every component in terms of base year.
Common size and Trend analysis are very basic methods and
typically detailed analysis using DuPont should be performed. Comparison should
be restricted within the industry as for each industry ratio and baselines will
be different.
Last but not the least - how these can be used? Do the analysis of the company which are publicly listed and if there are any stock which are beaten by the market but strong on fundamentals there you have got your pick of the portfolio.
P.S. - While writing these I was thinking that I am diluting the branding of the blog page. But then at the same time I thought probably my old blog page viewers are long gone because of my post frequency. So better to put something and move-on rather then making this page dead.