The basic understanding of financial statements is a pre-condition to performing financial analysis. It can start from a basic analysis and then expand into complex financial analysis.
Step 1: Operating margins
Operating Margin = Operating Profit / Net Sales
The operating profit = revenue - cost of goods sold (COGS) - operating expenses - depreciation - amortization.
Operating profit is also called Earnings Before Interest and Taxes (EBIT).
The trend must be seen over a period of 10 years to understand the trend. If the operating profit margin is low, it is an indicator that operating costs are too high and operating profit is low. It may also indicate that a minor change in demand may result in erosion of current profitability.
Step 2: ROE
Looking at operating margin is easy; many websites provide operating margin directly. The next step is to calculate RoE, Return on Equity.
Return on equity is a great overall measure of a company’s profitability because it measures the efficiency with which a company uses shareholders’ equity.
RoE = Net margin × Asset turnover × Financial leverage
RoE = (Net Profit / Net Sales) × (Net Sales / Total Assets) × (Total Assets / Shareholder’s Equity)
Net margin is net income divided by sales, and it tells us how much of each rupee of sales a company keeps as earnings after paying all the costs of doing business.
Asset turnover is sales divided by total assets, which tells us roughly how efficient a firm is at generating revenue from each rupee of assets.
Financial leverage is essentially a measure of how much debt a company carries, relative to shareholders’ equity.
Be careful of a high financial leverage ratio if a company’s business is cyclical or volatile.
Leverage on its own is not good or bad, it must be seen in the context of margin and asset turnover.
If you can find a company with the potential for consistent ROEs over 20%, there’s a good chance you are in for a high ride.
Step 3: ROIC
RoE calculated the common equity shareholder’s return. However, a company may source capital using debt as well. Return on Invested Capital (ROIC) helps in addressing this issue.
A high-ROIC company typically creates more value by focusing on growth, while a lower-ROIC company creates more value by increasing ROIC.
A loss-making company or a negative ROIC company, growing its sales will only increase losses. So, the growth will be detrimental.
ROIC = NOPLAT / Invested Capital
This calculation is complex and would need a fair understanding of accounting. Each item i.e. NOPLAT (net operating profit less adjusted taxes) and Invested capital is broken down into subparts.
The evaluation of a business’ operating efficiency using NOPLAT is not impacted by how much leverage the company has or how much loans it has on its balance sheet given that debt servicing, that is, the interest used to finance debt, negatively impacts a firm’s bottom line and, thus, decreases its tax expense.
Return on invested capital (ROIC) is used to gauge how well a company allocates capital to profitable activities. This is done using funds allocated towards working capital and other operating assets.
A consistent ROIC of over 20% indicates high quality. You must understand how sustainable ROIC is, this can be done by looking at the breakup of ROIC.
Cost structure and profitability analysis is done using NOPLAT breakup.
Whereas how efficiently assets are used comes from the invested capital breakup.
Asian paints NOPLAT margin is maintained between 14-19%, whereas capital efficiency is reducing with more funds getting allocated towards working capital and plant, property, and equipment.
The next step will be to understand why the allocation is increasing and how much profitability the company can generate due to this investment.
Start your analysis from operating margins, move to ROE and then to ROIC.