How to do Fundamental Analysis of a company?

Without doing a proper research of the stock its not advisable to take a call on the stock for investing your hard earn money. There are two types of the analysis available out there. 1) Fundamental analysis 2) Technical analysis.

We will cover both the analysis one by one. For this article, I will cover fundamental analysis. Will cover the technical analysis in the upcoming article.

What is the fundamental analysis?

Fundamental analysis is the basic while doing in-depth research on any company. This analysis consists of a study of financial ratio and future growth potential of the company. If you are from commerce background it will be much easier for you to understand the fundamental analysis. It is very easy to understand and anyone can learn from it. It is also known as a financial analysis of the company.

It consists of a different ratio derived from the Balance sheet, Profit & Loss Statement, and Cash Flow. These are the important aspect of an annual report of the company. By looking at these aspects and with the help of ratios one can conclude whether the company is worth investing or not. Different numbers in these statements are nothing but the financial health of the company.

Fundamental Analysis is the details study of how the company is doing in terms of sales, how it is managing its expenses and cost, what is the profit margin of the company, what is net profit, how much dividend company has paid, how much debt company has under its belt.

While doing the analysis, it is must you carry out analysis for long period instead of particular year or quarter. It is preferred to see the trend of at least 10 years as it will cover up one complete economic cycle.

Let’s understand the fundamental analysis of a company with an example.

I am using the website Screener.in for exporting financial data of the company. It’s very easy to search and download the financial data in Microsoft Excel worksheet. The best part is, you don’t have to calculate different ratios as its readily available.

Here I am using an example of a company Arvind Ltd.

Arvind Limited

On the right-hand side top, you can see the blue button “Export to Excel”. Please click on it and download the data in excel sheet on your computer.

Now, we will look into the company’s activity and performance for last 10 years.

1. Profit and loss statement analysis

This includes sales figures and income generated by the company. It also shows us the expenses of the company and eventually reveals the profit or loss of the company.

a) Sales trend:

The first thing we should check is the sales figures for the company. It is revenue for any company. It will tell us how the company’s product or service is doing in the market and if the company is growing or not?

Here you can see the sale is growing year on year from 2674 crore in 2008 to 9235 crore in 2017 at the CAGR of 14.77%

There is not a single year where sales growth is lesser than the previous year. 14.77% growth rate is ok but not great as it is equivalent to the GDP growth + inflation of Indian economy.

b) Profit Margins

Operating Profit Margin and Net profit Margin are the two important parameters to check the profitability of the company.

OPM is the money left after paying the operating expense. Operating Expense is the raw material cost to make a product of the company, manufacturing cost, employee cost and any other cost like fuel and power.

Operating Profit does not include expense like depreciation of the fixed asset, interest expense for the loan taken and the taxes which company pays. It is also known as direct expenses or direct cost.

OPM = Operating Profit/ Sales

The company’s OPM is around 12% for the last 10 years. Increasing or stable operating profit margin is a good sign, it means the company has a control over its operating cost.

NPM = Net Profit/Sales

net profit margin

Company’s net profit margin is low at around 3% to 4% which is not so good. As an investor, you should look for the company which maintains high-profit margin year on year.

c) Tax Rate

Paying regular tax is a good sign of accounting standard of the company. In India, the corporate tax rate is 30%. You should look for the company which pays regular tax.

If the company is not paying tax or paying very little tax then you should check the reason behind that. In India, there are many sectors where tax is exempted under certain government schemes.

Tax Rate = Tax /Profit Before Tax

You can check the Arvind Limited has not paid a tax of 30%. The company enjoys tax benefits as it is in the textile sector where tax is less or exempted. As an investor, you should check whether the company enjoys the tax benefits before taking any decision.

d) Interest Coverage Ratio

This ratio will tell you whether the company has enough profit to pay the interest amount. Interest Coverage ratio > 2 is considered to be good.

Interest Coverage Ratio = Operating Profit/Interest expense

If the Company is Having Interest Coverage Ratio of Rs 4, it simply means for that for Rs 1 of Interest expense, Company is able to make an operating profit of Rs 4.

Higher Interest Coverage Ratio provides a great safety during bad economic condition.

interest coverage ratio

The company has an interest coverage ratio of 3.03 for the year 2017 which will provide good safety in rough time of the company. It means the company has enough operating profit that it can pay interest amount to the lender during the tough time as well.

2. Balance sheet statement analysis

The balance sheet is the core snapshot of the company’s financial health. It is known as a financial health card of the company. It provides information about the asset and liabilities of the company for the given time period.

a) Debt/Equity Ratio (D/E)

If you are from commerce background you can read balance sheet easily. The liability side of the balance sheet provides information about the source of funds i.e. share holder’s fund, borrowed funds (loans)

Any company doing business needs capital for purchasing plant and machinery for its production. To buy the assets, it needs money. There is two source of money as I have mentioned above i.e. shareholder’s fund or borrowed fund (loan).

This ratio measures how much fund the company has to repay the debt.

Debt/Equity Ratio measures how much funds have come from debt in a form of a loan or from its own company in a form of shareholders equity. If the D/E ratio is 1, it means 50% of the fund is borrowed from lenders and 50% from shareholders equity.

D/E = Total Debt/Total Shareholder’s Fund

Look for the company having a lower D/E ratio. it should preferably less than 1 and should be a decreasing year on year. During bad times, if a company is not making money, lenders will ask to return back their money. In such a scenario, it will sell off its asset to return the money and leaving nothing for the shareholders.

de ratio

Arvind Ltd. has consistently reduced its debt and in 2017 it had a D/E ratio of 1 which is a great result and shows good business handling ability of the management. This means the company can sustain itself during the tough time and is able to pay off the debt if something goes wrong.

3. Cash flow statement analysis

This segment will tell you how and where the cash is being sued by the company. It has 3 parts.

  1. Cash flow from operation (CFO) – It gives information about the cash received through the main operation of the business in the financial year.
  2. Cash flow from Investment (CFI) – It gives detailed information about the cash used to buy the asset or cash received by selling an asset.
  3. Cash flow from Financing (CFF) – It gives information about the cash inflow due to borrowing from financial institution and repayment during the year.

An investor should look for a company which generates a great amount of cash flow from operation. Look for a company whose CFO can take care of CFI and CFF.

cash flow

Remember, here all the negatives are not bad.

The negative signs indicate the outflow of cash from the company. If CFO is into negative, the company has generated nothing out of its day to day operation.

If CFI is negative means the company has bought some asset and pay cash for it.

If CFF is negative the company is repaying the borrowing. – repayment of the loan.

Net Cash = CFO + CFO + CFF. Net Cash is the cash left with the company after doing all the three operations

In the case of Arvind Ltd, it has generated a healthy amount of CFO year on year. Its CFO has increased from Rs 296 Cr in 2008 to Rs 543 Cr in 2017.

NET PROFIT  VS CFO

A company that sells products or provides services may not receive its payment immediately. However, accounting standards may allow it to report its sales and net profit in P& L Statement. But the actual cash received from the customers will be reflected in Cash Flow Statement.

For example, suppose the company is selling a pen. It sells a pen to a particular customer and he tells a company that he will pay on the later date. As per accounting standards company can make an entry of a sales in P&L Statement even though it has not received cash. Its a duty of the company to collect the money from the customers. This money received is actual cash which always gets reflected in Cash Flow Statement.

We should check PAT and CFO over a long period of time. If CFO=PAT or CFO>PAT, it means the company is able to collect cash from the customers and if PAT > CFO, it simply means that company is unable to collect the cash and the profit mentioned is not true.

coo vs pat

In the above table, it is clearly evident that Arvind Limited is generating higher cash from the operations, means they are able to collect the cash from the customers. It has managed to generate CFO of rs. 543 cr. as compare to a PAT of Rs. 238 cr.

Summary

Let’s have a quick recap…

Sales Growth > 14% for 7 to 10 year in past

OPM & NPM: It should be high and sustainable. NPM > 9% is good.

Tax Rate: It should be more than 30%. If it is less check the reason behind it.

Interest Coverage Ratio > 2

D/E < 1

CFO>0

CFO>PAT or CFO = PAT

Do it Yourself – DIY

Now as you know the logic of doing fundamental analysis, why not try your hands on it?

I have designed a simple excel sheet ready for you. You are required to enter only some data points in the excel sheet. I have marked the required field in Yellow cells. you are required to fill up only those yellow cells in the excel sheet. All the required data points are readily available from www.screener.in as I mentioned above.

With the help of the excel sheet, you can do the fundamental analysis by yourself and make a decision about your trade call. It will give you a score for each parameter. There are total 8 parameters with the highest score of 5 each. So the maximum score for any script will be 40. Any script scoring up to 20 is not so good. score from 21 to 30 is a medium score, and > 30 is a good score. Below is the snapshot of the scorecard for one script.

As you can see the score below is 21, which is an average score. You can see where the company is doing well and well it’s lagging behind. The company is lagging behind in net profit and cash flow.

summary

Download FREE Excel sheet for Fundamental Analysis

Please share this article with your friends so that they can also take the benefit of this tool. It is free, it is fast, it is reliable.

You can download various e-books on the stock market for free.

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