How to analyse financial statements?
Updated: Aug 9, 2021
You should seek a business that offers a superior product or service to customers, enabling the company to generate impressive financial returns and prevent competition from eroding them. You can identify these businesses by evaluating their ROCE or ROIC.
As businesses deliver well on ROCE or ROIC, you should continue to follow their performance and deep dive further.
A business with a product or a service that has high demand will show increased revenue.
Amrutanjan Healthcare Ltd has increased its sales annually by 12%, which is greater than 7% GDP growth in India. This trend should show up in quality businesses over five year or plus range.
ROCE or ROIC should be used as the first filter before any other metric. The further drill down should be on the margins. Look for businesses that can expand their margins. Note that margin expansion should be sustainable rather than a one-year event. For example, work from home has helped companies save on office rentals. Depending upon the business, the cost reduction may be sustainable or not.
The interest coverage ratio indicates whether the operating profits are sufficient to pay interest to the lenders.
Interest Coverage Ratio = Operating Profit / Interest Expense
A company that has high ROIC and low debt levels should have high-interest coverage. However, a highly levered company may have a low-interest coverage ratio (less than 3).
Free Cash Flow
Free cash flow is the money that belongs to the company's owners after meeting all the expenses. Free Cash Flow (FCF) can be calculated as:
FCF = NOPAT + Depreciation - Capital Expenditure – Investment in working capital
A company that cannot generate free cash flow will not be able to exist for long. I will repeat what Jim Collins has mentioned in his bestseller, Built to Last:
“What God did was to put in place a universe with certain principles, and what we need to do is figure out how those principles work. God doesn’t make all the decisions. He set in place processes and principles that would carry on.”
A business that can stay relevant and profitable for a long-time will often be a wealth compounder.
The information contained on this website and the resources available for download through this website is not intended as, and shall not be understood or construed as, financial advice. You should consult with a financial professional to address your particular information.