Qualitative Analysis
Qualitative analysis involves evaluating a company’s performance to assist investors in selecting profitable stocks. A company’s past performance is crucial in predicting its future profitability.
Profit and Loss Analysis
- Net Sales: Net sales is a vital metric calculated by deducting all indirect taxes, such as excise duty and value-added tax, from gross sales. It is important to analyze net sales across different segments, as growth in sales can come from diversifying into new products and markets.
- Direct Costs: Direct costs are expenses directly attributable to the business, such as raw materials, salaries, and utility costs. Reducing operating costs translates to higher profitability. Lowering direct costs enhances the operating efficiency of a firm; companies with high fixed costs particularly benefit from operating leverage.
- EBITDA: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) measures the operating efficiency of a company and is calculated as net sales minus direct costs. A higher EBITDA indicates a healthier firm.
- EBITDA Margin: This margin represents EBITDA as a percentage of net sales. A higher EBITDA margin is indicative of better company performance.
- Depreciation/Amortization: When a company purchases assets for long-term use, depreciation is applied to tangible assets, while amortization refers to the depreciation of intangible assets like copyrights and brand value. By subtracting depreciation and amortization from EBITDA, we arrive at EBIT (Earnings Before Interest and Taxes).
- Interest: Interest is an expense incurred on loans that the business has taken. High-interest expenses are generally unfavorable as they indicate a higher debt burden. Sound business or investment decisions can lead to satisfactory economic outcomes.
- Other Income: This refers to recurring income from sources such as rent, interest, dividends, and commission. While it can be beneficial, it should typically represent only a small portion of a company’s net revenue, as excessive reliance on other income warrants further analysis.
- PBT (Profit Before Tax): This is the profit calculated after deducting interest and depreciation/amortization from EBITDA. A higher PBT is favorable.
- PAT (Profit After Tax): This represents the final profit available to the company after all expenses, including taxes, have been paid.
Balance Sheet
A balance sheet details a company’s sources and uses of funds at any given point in time.
- Equity: Equity represents ownership in a company. It includes the promoter’s initial investment, along with funds raised from new shareholders as the business expands.
- Reserves and Surplus: This line item reflects the accumulated profits retained in the business over time. A higher reserve and surplus is a positive sign for analysts.
- Net Worth: Net worth is calculated by adding reserves and surplus to equity. A high net worth is favorable for analysis, making the company’s stock a potential choice for investors.
- Long-Term Debt: Long-term debt refers to loans that need to be repaid over a period exceeding one year.
- Current Liabilities: These are obligations that must be settled within a year, including salaries, utility payments, and trade payables.
- Short-Term Debt: This is raised through mechanisms like issuing commercial papers or unpaid dividends and is crucial for working capital efficiency.
- Fixed Assets: Fixed assets are tangible items a company acquires to produce goods and services, such as machinery, furniture, and vehicles.
- Current Assets: Current assets are assets that can be converted into cash within a year. Examples include short-term loans, advances, and cash.
Cash Flow Statement
Cash generation is vital for the long-term viability of a business and is categorized into three types.
- Operating Cash Flow: This cash flow comes from operating activities. A company can adjust its net income to reflect operating cash flow by adding back non-cash expenses like depreciation and amortization.
- Investing Cash Flow: Cash flow related to buying assets leads to negative cash flow while selling assets results in positive cash flow.
- Financing Cash Flow: Cash flow from liabilities—such as borrowing money and issuing equity—is positive, while repaying debt or equity results in negative cash flow.
If a business consistently shows negative operating cash flow over several years, this may signal a significant risk.