Saturday, June 14

Company Analysis - Qualititive Factors

The Company Analysis
The different issues regarding a company that should be examined are:
The Management
The Company
The Annual Report
Ratios
Cash flow

Management is the single most important factor to consider in a company. Upon its quality rests the future of the company. A good, competent management can make a company grow while a weak, inefficient management can destroy a thriving company. Investors must check on integrity of managers, proven competence, how high is it rated by its peers, how did it perform at times of adversity, the management's depth of knowledge, its innovativeness and professionalism.

A company may have made losses consecutively for two years or more and one may not wish to touch its shares - yet it may be a good company and worth purchasing into. There are several factors one should look at.
Another aspect that should be ascertained is whether the company is the market leader in its products or in its segment. When you invest in market leaders, the risk is less. The shares of market leaders do not fall as quickly as those of other companies.
The policy a company follows is also of imperative importance. What are its plans for growth? What is its vision? Every company has a life. If it is allowed to live a normal life it will grow upto a point and then begin to level out and eventually die. It is at the point of leveling out that it must be given new life.
Labour relations are extremely important. A company that has motivated, industrious work force has high productivity and practically no disruption of work. On the other hand, a company that has bad industrial relations will lose several hundred mandays as a consequence of strikes and go slows.

The Annual report is the primary and most important source of information about a company is its Annual Report. By law, this is prepared every year and distributed to the shareholders. Annual Reports are usually very well presented. A tremendous amount of data is given about the performance of a company over a period of time. The Annual Report is broken down into the following specific parts:
A.The Director's Report,
B.The Auditor's Report,
C.The Financial Statements, and
D.The Schedules and Notes to the Accounts.
E. Management Discussion and Financial Analysis

A Director’s Report is valuable and if read intelligently can give the investor a good grasp of the workings of a company,
The problems it faces, the direction it intends taking, dividends proposed and the future prospects of the company. The Director’s Report gives investors insights into the company. and enunciates the opinion of the directors on the economy, the industry and political situation.

The auditor represents the shareholders and it is his duty to report to the shareholders and the general public on the stewardship of the company by its directors. Auditors are required to report whether the financial statements presented do, in fact, present a true and fair view of the state of the company. It is really the only impartial report that a shareholder or investor receives and this alone should spur one to scrutinize the auditor's report minutely. The Auditors in the Auditors report will comment on any changes made in accounting principles and the effect of these changes made in accounting principles and the effect of these changes on the results. They will also comment on any action or method of accounting they do not agree with.

Financial statements of a company in an annual report consist of the balance sheet, the profit and loss account and the cash flow statement. These detail the financial health and performance of the company.

The balance sheet details all the assets and liabilities a company has on a particular date. Assets are those that the company owns such as fixed assets (buildings, cars etc.), investments and current assets (stocks, debtors and cash). Liabilities are those that the company owes (trade creditors, loans, etc.) and the shareholders investment in the company (share capital and reserves). Although every bit of information available in the Balance Sheet, one must definitely look into Share capital, Reserves, Loans (both Secured and Unsecured), Working Capital (Current Assets – Current Liabilities) with special emphasis on Inventories and its valuation, and Investments. Cash can be better analysed from the cash Flow Statement. Have we spared anything in the Balance Sheet? Probably not!

The Profit and Loss account summarizes the activities of a company during an accounting period which may be a month, a quarter, six months, a year or longer, and the result achieved by the company. It details the income earned by the company, its cost and the resulting profit or loss. It is, in effect, the performance appraisal not only of the company but also of its management - its competence, foresight and ability to lead. Major items to look for in the profit & Loss Statement are Sales or Primary Income, compared with other income, if any. This helps us compare if the company has earned profit from its core operations that are likely to sustain or from non core operations (like other income, dividend from investments, interest on investments, rent from leased assets or profit from sale of assets) that may not sustain in the future. On the expenses side, operating and other expenses like salaries, selling expenses, administrative expenses and the like are to be analysed including depreciation, Interest and Finance charges. Taxation, Dividends proposed, Interim Dividend, Transfer to Reserves are other important items in the Profit & Loss Statement.

The notes to the accounts are even more important than the schedules because it is here that very important information relating to the company is stated. Notes can effectively be divided into:
(a) Accounting Policies
All companies follow certain accounting principles and these may differ from those of other entities. As a consequence, the profit earned might differ. Companies have also been known to change (normally increase) their profit by changing the accounting policies. The accounting policies normally detailed in the notes relate to: How sales are accounted? What the research and development costs are? How the gratuity liability is expensed? How fixed assets are valued? How depreciation is calculated? How stock, including finished goods, work in progress, raw materials and consumable goods are valued? How investments are stated in the balance sheet? How has the foreign exchange translated? And so on.
(b) Contingent Liabilities
All contingent liabilities are detailed in the notes to the accounts and it would be wise to read these as they give valuable insights. The more common contingent liabilities that one comes across in the financial statements of companies are:
Outstanding guarantees. Outstanding letters of credit. Outstanding bills discounted. Claims against the company not acknowledged as debts. Claim for taxes. Cheques discounted. Uncalled liability on partly paid shares and debentures.
(c) Others
The more common notes one comes across are: Whether provisions for known or likely losses have been made? Estimated value of contracts outstanding. Interest not provided for. Arrangements agreed by the company with third parties. Agreements with labour.

It is to be kept in mind that no investment should be made without analyzing the financial statements of a company and comparing the company's results with that of earlier years.

Ratios express mathematically the relationship between performance figures and/or assets/liabilities in a form that can be easily understood and interpreted. It is in the analysis of financial statements that ratios are most useful because they help an investor to compare the strengths, weaknesses and performance of companies and to also determine whether it is improving or deteriorating in profitability or financial strength
Sales of Rs.500 million a year or a profit of Rs.200 million in a year may appear impressive but one cannot be impressed until this is compared with other figures, such as the company's assets or net worth or capital employed. It is also important to focus on ratios that are meaningful and logical . Otherwise, no useful conclusion can be arrived at. A ratio expressing sales as a percentage of trade creditors or investments is meaningless as there is no commonality between the figures. On the other hand, a ratio that expresses the gross profit as a percentage of sales indicates the mark up on cost or the margin earned.
Ratios can be broken down into four broad categories:
(A) Profit and Loss Ratios
These show the relationship between two items or groups of items in a profit and loss account or income statement. The more common of these ratios are:
1. Sales to cost of goods sold.
2. Selling expenses to sales.
3. Net profit to sales and
4. Gross profit to sales.
(B) Balance Sheet Ratios
These deal with the relationship in the balance sheet such as :
1. Shareholders equity to borrowed funds.
2. Current assets to current liabilities.
3. Liabilities to net worth.
4. Debt to assets and
5. Liabilities to assets.
(C) Balance Sheet and Profit and Loss Account Ratios.
These relate an item on the balance sheet to another in the profit and loss account such as:
1. Earnings to shareholder's funds.
2. Net income to assets employed.
3. Sales to stock.
4. Sales to debtors and
5. Cost of goods sold to creditors.
(D) Financial Statements and Market Ratios
These are normally known as market ratios and are arrived at by relation financial figures to market prices:
1. Market value to earnings and
2. Book value to market value.
Ratios do not provide answers. They suggest possibilities. Investors must examine these possibilities along with general factors that would affect the company such as its management, management policy, government policy, the state of the economy and the industry to arrive at a logical conclusion and he must act on such conclusions. Ratios are a terrific tool for interpreting financial statements but their usefulness depends entirely on their logical and intelligent interpretation.

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