Financial Statement readings and a Quick checklist

a) It never hurts to revert to basics (not once in a while, but all the time) and these blogposts from Jae Jun summarize what most of us want to know – how do we know whether the company has any durable competitive advantages? The more important question is, how can I know this easily rather than the tiresome activity of going through Annual Reports one by one (start with the ‘A’s as Warren Buffett said)  and find out firms which have unique licensing contracts (like Page Industries, Cravatex, Astral Polytechnik etc.) or are distribution kings (Asian Paints, ITC etc.). The easiest way is the quantitative way and Jae Jun takes us step by step through each of the financial statements. Must read.

i) Balance Sheet

ii) Income Statement

iii) Cash flow Statement

b) Before getting into the comprehensive checklist as stated above, I have a quick checklist to see whether I would like to further dig into the company.

i) Do I understand the industry that the company operates? (for example, I can’t understand the Oil industry for the world, and hence whenever I hear ‘check out HPCL, IOC, Chennai Petro, Panama Petro etc.’, I switch off my brain (actually, that’s my default state and it requires humungous efforts to turn it on)).

ii) Debt – I usually give a pass to companies with high debt. But what is ‘high’? Well, there are a couple of checks here. I would not analyze a company further if the debt ratio is greater than 25%. Secondly, I would check its peers in the same industry and look at their debt levels. If the comparitive debt is high, I drop analyzing the company.

iii) I am a big fan of the Du-Pont formula. In essence, Du-pont formula tries to arrive at Return on Capital Employed (RoCE) through a couple of factors. a) Capital Turnover b) Profit margins. The key is not to take a single year’s snapshot but to analyze atleast 5 years of data (10 years would be better, but ET and Moneycontrol have only 5 years of data and I am not rich enough to procure data from Religare) and check the average capital turnover and average profit margins. The best case scenario is increasing capital turnover (and hence becoming lesser capital intensive) and increasing profit margins (implying pricing power). I drop analysing the company if both are dropping continously for the past 3 years. Alternatively, I drop analyzing companies with RoCE less than 20% (Think of it this way: Let’s say I invest Rs. 10000 in a particular stock (my capital). Why would I be interested in this stock if the rate of return on this capital (and hence RoCE) is 10-12%? I can get that return by investing in a fixed deposit with almost no chance of a downside. Hence my hurdle rate is 20% – atleast double the fixed deposit rate – that doesn’t mean my rate of return on the invested stock WILL be 20%, rather I try to estimate the return to be as close to RoCE of the firm as possible – no guarantees though).

iv) Cash/Investments – What percentage of market cap is cash/investments? The reason being, higher the percentage of cash/investments in the market cap, lesser is the downside. However, this cash component requires further digging (say for example, whether investments are recoverable almost immediately or whether that percentage of cash is required as working capital due to the nature of the industry or whether there has been a recent sale of a unit of the company or whether they has been any equity offering etc.). Digging aside, just for a quick glance, this cash ratio helps immensely to weed out many companies.

v) Current ratio – If the current ratio is less than 1, the company might be operating on negative working capital. This requires further digging (sometimes customers might be paying in advance for product procurement like VST Industries, HLL, Colgate etc.) but for a quick pass, current ratio greater than 2 would be better.

vi) Cash generated from Operations – This one is from the Cash flow statement, and probably my most important figure. Check the cash flow from operations for the past 5 years. If its negative for the all the 5 years, ditch the company analysis (implication: they are losing money from their operations and are probably funding from equity/debt offerings). If I want to go one step further, I will calculate Cashflow Return on Invested capital (this is similar to RoCE, but is done with cashflow) (formula: Average cashflow from operations/Avg. Capital employed).

vii) Check whether earnings are real – Sometimes (remember Enron, Worldcom etc.) the reported earnings are not real. I perform a quick check (again, for the past 5 years) to see if the reported earnings are real. I check Operating profit against the difference between Cash generated from Operations and Depreciation (for the mathematically inclined Operating Profit ~ Cash generated from operations – Depreciation). If there is a wide difference year on year over the period of 5 yrs (or 10 yrs if you have the data), the reported earnings are not real and I stop the company analysis (Please don’t try to short the company – remember Keynes ‘the markets can be irrational longer than you can be solvent’).

viii) After all these 7 points, I’d like to see if the company is increasing its revenues year on year (for 5/10 yrs of data). Revenue being the first item on the P&L statement, there are very few avenues to manipulate this part (although, it still can be done), but as you go down the P&L, chances of manipulation increase dramatically. I am ok with a one or two year dip in revenue, but 3 continuous years of dropping revenue will screen this stock out of my radar.

These 8 points can seem like a lot of work, but believe me you when I say this – once you do this for about 5-10 companies diligently, this analysis wouldn’t take more than 15-30 minutes max after that for all other companies. There are lots of companies which pass all these 8 criteria and you need as much time as possible for further digging before investing. This quick checklist will only ensure that a) you don’t waste time digging into dud companies and b) you reduce chances of losing your money substantially (upside will come, as long as downside is taken care of).

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  1. #1 by Rohan Pinto on September 4, 2011 - 10:28 PM

    Thanks Kiran..!!! Avid reader of your blog.. Its always good to strengthen one’s basics!! Appreciate your efforts.!

  2. #2 by Furqan on September 6, 2011 - 2:27 PM

    Very informative post.
    I am new to your blog. signed up today.

  3. #3 by Jazz on September 10, 2011 - 8:01 PM

    would like ur view on AK CAP as a Value Buy or a value Trap cash bargain ?

  4. #4 by Kiran on September 19, 2011 - 8:44 PM

    @Rohan, @Furqan – Thanks.

    @Jazz – My conviction on AK is too low – I wouldn’t call it a value trap or a value buy since I have not analyzed it in depth. However, the feedback I hear about AK is not good. I would avoid this stock. Disc: No positions

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