Chapter 8: Company Analysis – Financial Analysis – Outline

Section Title Description
8.1Introduction to Financial StatementExplains the components and purpose of financial statements.
8.2Stand-alone and Consolidated Financial StatementsDifference between company-only and group-level reporting.
8.3Balance SheetAnalyzes assets, liabilities, and net worth at a specific point in time.
8.4Basics of Profit and Loss Account (P&L)Tracks revenues, expenses, and net profit over a period.
8.5Statement of Changes in Shareholders’ EquityShows changes in capital, reserves, and retained earnings.
8.6Basics of Cash FlowsEvaluates cash generated from operations, investing, and financing.
8.7Notes to AccountsProvides supporting information for understanding financial data.
8.8Important Points to Consider in FinancialsKey insights, red flags, and analytical observations from financials.
8.9Reading Audit Reports for Quality of AccountingEvaluates audit opinion, notes, and transparency of accounting practices.
8.10Financial Statement Analysis Using RatiosCovers solvency, liquidity, profitability, and efficiency ratios.
8.11Commonly Used RatiosHighlights frequently used ratios with formulas and purpose.
8.12DuPont AnalysisDecomposes ROE into profitability, efficiency, and leverage components.
8.13Forecasting Using Ratio AnalysisUsing past ratios and trends for forward financial projections.
8.14Peer ComparisonCompares financial and valuation metrics across competitors.
8.15Other Aspects in Financial ReportsMiscellaneous insights such as segment reporting, related party disclosures.

8.1: Introduction to Financial Statement

Financial statements are structured reports that provide a clear picture of a company’s financial performance and position. They help stakeholders — including investors, analysts, lenders, and regulators — understand how a company earns revenue, manages expenses, deploys capital, and meets its financial obligations.

📊 Key Components of Financial Statements

  • Balance Sheet: Shows the company’s assets, liabilities, and equity at a particular point in time.
  • Profit and Loss Account (P&L): Also known as the income statement, it reflects the revenues and expenses over a period.
  • Cash Flow Statement: Tracks actual cash inflows and outflows across operations, investments, and financing.
  • Statement of Changes in Equity: Captures movement in share capital and reserves.
  • Notes to Accounts: Offers additional clarity and breakdown of line items in the main statements.

📌 Why Financial Statements Matter

  • They are the foundation of financial analysis, ratio calculation, and forecasting.
  • Enable comparisons across time and between peers in the same sector.
  • Ensure transparency and accountability in reporting financial performance.
  • Regulated by accounting standards (Ind AS in India) and verified by auditors.

🎯 Analyst Tip

  • Always read the notes to accounts and auditor’s report — they often reveal red flags.
  • Compare both standalone and consolidated numbers to understand the full business scope.
  • Look for consistency, transparency, and clean disclosures across statements.

8.2: Stand-alone and Consolidated Financial Statements

A company may operate through multiple subsidiaries, joint ventures, or associate firms. To reflect the complete financial position, companies prepare two types of statements:

📄 Definitions

  • Stand-alone Financial Statement: Shows the financial position and performance of the company alone, excluding any of its subsidiaries or affiliates.
  • Consolidated Financial Statement: Combines the parent company’s financials with its subsidiaries, joint ventures, or associates as if they were a single entity.

📘 Stand-alone Financials

  • Includes only the parent company’s operations.
  • Used for internal decision-making or statutory filing.
  • Does not reflect full group performance.
  • Example: Infosys India entity numbers only.

📙 Consolidated Financials

  • Includes parent + subsidiaries + JVs + associates.
  • Used for investor analysis and stock valuation.
  • Shows group-level performance and risk exposure.
  • Example: Infosys Global financials (India + overseas).

🎯 Why Analysts Must Compare Both

  • To assess how much of the total revenue and profit comes from subsidiaries vs core business.
  • To identify risks or dependencies at the group level.
  • Discrepancies between the two may highlight non-performing subsidiaries or inter-company transactions.

📦 Case Example: TCS (FY23)

TCS is a global IT services company with operations across multiple geographies and subsidiaries. Here’s how its standalone and consolidated revenues compare:

📘 Stand-alone Financials

  • Revenue: ₹1,59,000 Cr
  • Includes: Core India-based operations only
  • Excludes: Overseas subsidiaries, acquisitions, joint ventures

📙 Consolidated Financials

  • Revenue: ₹2,25,458 Cr
  • Includes: All global subsidiaries, branches, and service lines
  • Used By: Analysts, investors, credit agencies for true group-wide performance

Insight: Over 29% of TCS’s total revenue comes from its international subsidiaries. Relying only on standalone numbers can significantly understate the company’s size and performance.

8.3: Balance Sheet

The balance sheet provides a snapshot of a company’s financial position at a specific point in time. It shows what the company owns (assets), what it owes (liabilities), and the residual value for shareholders (equity). The fundamental formula is:

📐 Basic Balance Sheet Equation

Assets = Liabilities + Shareholders’ Equity

8.3.1 📊 Common Balance Sheet Line Items

💰 Current Assets

Cash, trade receivables, inventory, and short-term investments.

Example: ₹8,000 Cr in cash & bank balance with Infosys.

🏭 Non-Current Assets

Property, plant & equipment, goodwill, long-term investments.

Example: Tata Steel’s factories under PPE.

📦 Current Liabilities

Trade payables, short-term borrowings, and other dues due within 1 year.

Example: Vendor bills unpaid by HUL.

🏦 Non-Current Liabilities

Long-term borrowings, lease liabilities, deferred tax liabilities.

Example: Long-term bonds issued by NTPC.

📘 Shareholders’ Equity

Equity share capital + reserves and surplus.

Example: ₹30,000 Cr equity in Reliance Industries.

8.3.2 🧮 Balance Sheet Metrics

These metrics help assess liquidity, leverage, and capital strength.

📉 Current Ratio

Formula: Current Assets / Current Liabilities

Ideal: >1.5
Use: Measures short-term liquidity.

🏦 Debt-to-Equity Ratio

Formula: Total Debt / Equity

Ideal: < 1 for non-capex-heavy sectors.
Use: Shows leverage risk.

⚖️ Net Worth

Formula: Share Capital + Reserves – Accumulated Losses

Use: Indicates book value of shareholders’ interest.

💡 Capital Employed

Formula: Equity + Long-term Debt

Use: Helps assess returns (ROCE).

🎯 Analyst Insights

  • Review the debt structure — working capital loans vs long-term loans.
  • Check for red flags like negative net worth, high debt-to-equity, or rising current liabilities.
  • Compare the asset growth to liability buildup — high asset growth backed by debt can be risky.

8.3: Balance Sheet

The balance sheet is a financial snapshot that reflects what a company owns 🟢(Assets), what it owes 🔴(Liabilities), and the residual value for shareholders 🟢(Equity). It follows the equation:

📘 Accounting Equation

Assets = Liabilities + Shareholders’ Equity

8.3.1 🧾 Common Balance Sheet Line Items (with examples)

🟢 Current Assets

  • Cash & Cash Equivalents: ₹6,200 Cr in TCS’s FY23 report.
  • Trade Receivables: Amounts due from customers, e.g., ₹4,500 Cr for HUL.
  • Inventory: FMCG & Auto companies hold finished goods, raw materials (e.g., Maruti).

🟢 Non-Current Assets

  • PPE: ₹18,000 Cr of plants and factories in Tata Steel.
  • Goodwill: Arising from acquisitions — common in tech & pharma.
  • Long-term Investments: Investments in subsidiaries like HDFC’s in HDFC Bank.

🔴 Current Liabilities

  • Trade Payables: ₹2,200 Cr in unpaid dues to vendors.
  • Short-term Borrowings: Working capital loans for cyclical businesses like textiles.
  • Statutory Liabilities: GST, TDS, or employee dues pending.

🔴 Non-Current Liabilities

  • Long-term Debt: ₹30,000 Cr in infrastructure-heavy firms like NTPC.
  • Lease Liabilities: Long-term real estate or equipment leases.
  • Deferred Tax Liabilities: Taxes payable in future periods.

🟢 Shareholders’ Equity

  • Share Capital: ₹500 Cr in Infosys equity shares.
  • Reserves & Surplus: ₹25,000 Cr retained earnings from previous profits.

8.3.2 📐 Key Balance Sheet Metrics

These metrics help evaluate financial strength, solvency, and liquidity:

💧 Current Ratio

Formula: Current Assets / Current Liabilities

Example: 2.1 for Nestlé India — indicates strong liquidity.

🔥 Quick Ratio

Formula: (Current Assets – Inventory) / Current Liabilities

Use: Measures true short-term solvency.

⚖️ Debt-to-Equity Ratio

Formula: Total Debt / Shareholders’ Equity

Example: 0.3 for Infosys vs 1.9 for Adani Power — shows leverage gap.

💰 Net Worth

Formula: Equity Capital + Reserves

Purpose: Reflects the book value of shareholders’ ownership.

🏗 Capital Employed

Formula: Equity + Non-Current Debt

Used For: ROCE analysis.

🔁 Working Capital

Formula: Current Assets – Current Liabilities

Use: Indicates short-term financial buffer.

🎯 Analyst Tips

  • 🟥 Look for rising liabilities without corresponding asset growth — a red flag.
  • 🟩 High reserves often reflect past profitability — cross-check with P&L.
  • 🟩 A low debt-to-equity ratio means lower risk but may also limit growth if under-leveraged.
  • 🟥 Negative working capital in FMCG (like HUL) is normal — but risky in capital-intensive sectors.

📊 Balance Sheet Analysis Template

Line Item FY23 FY22 FY21
🟩 Assets
Cash & Cash Equivalents
Trade Receivables
Inventories
Short-Term Investments
Other Current Assets
Property, Plant & Equipment (PPE)
Capital Work-in-Progress (CWIP)
Goodwill / Intangibles
Long-Term Investments
Deferred Tax Assets
🟥 Liabilities
Trade Payables
Short-Term Borrowings
Current Maturities of Long-Term Debt
Statutory Dues / Other Current Liabilities
Long-Term Borrowings
Lease Liabilities
Deferred Tax Liabilities
Provisions (Short/Long-Term)
🟩 Shareholders’ Equity
Equity Share Capital
Reserves & Surplus
Non-Controlling Interest (Consolidated)
📐 Balance Sheet Ratios
Current Ratio
Quick Ratio
Debt to Equity Ratio
Net Worth
Capital Employed
Asset Turnover Ratio

8.4: Basics of Profit and Loss Account (P&L)

The Profit and Loss (P&L) statement reflects the financial performance of a company over a specific period. It shows whether the company made a profit or incurred a loss by comparing its revenues and expenses.

8.4.1 🧾 Common Profit and Loss Account Line Items

🟩 Revenue

Total income from operations (product or service sales).

Example: ₹70,000 Cr from IT services (TCS).

🟥 Cost of Raw Materials

Direct cost of input goods used in production.

🟥 Purchase of Stock-in-Trade

Goods purchased for direct resale (trading companies).

🟥 Changes in Inventory (WIP + Finished Goods)

Adjustment based on inventory increase or depletion.

🟥 Employee Cost

Salaries, wages, provident fund, bonuses.

🟥 Depreciation and Amortisation

Non-cash reduction in value of tangible & intangible assets.

🟥 Finance Cost

Interest on loans and lease obligations.

🟥 Other Expenses

Admin, selling, travel, R&D, legal costs.

🟩 Income from Equity Accounted Entities

Share of profits from joint ventures or associates.

🟩 Exceptional / Non-Recurring Items

One-time gains/losses like asset sales or write-offs.

🟥 Tax

Includes current tax + deferred tax provision.

🟩 Profit Attributed to Non-Controlling Interest

Minority interest share in subsidiaries (consolidated).

🟩 Earnings Per Share (EPS)

PAT ÷ Number of Shares. Measures shareholder return.

🟩 Other Comprehensive Income (OCI)

Unrealized gains/losses on investments, forex, revaluation reserves.

8.4.2 📐 Key Metrics from Profit and Loss Account

📈 Gross Profit

Formula: Revenue – COGS

Indicates core manufacturing margin.

📊 EBITDA

Formula: Earnings before interest, tax, depreciation & amortisation

Shows operational efficiency.

📉 EBIT

Formula: EBITDA – Depreciation

Profit before financing & tax cost.

✅ Adjusted PAT

Formula: PAT after removing one-offs

Better for comparing operating performance YoY.

🎯 Analyst Tips

  • 🟢 Look for consistent PAT & EBITDA margins across quarters.
  • 🟥 Beware of high “Other Income” — may not be sustainable.
  • 🟢 Check if OCI includes forex or investment-related changes.
  • Always evaluate EPS growth along with revenue trends.

📊 Profit and Loss Analysis Template

Line Item FY23 FY22 FY21
🟩 Income
Revenue from Operations
Other Income
Income from Equity Accounted Entities
Exceptional / Non-Recurring Items
🟥 Expenses
Cost of Raw Materials
Purchase of Stock-in-Trade
Changes in Inventory (WIP + Finished Goods)
Employee Cost
Depreciation and Amortisation
Finance Costs
Other Expenses
🟩 Profit & Tax
Profit Before Tax (PBT)
Tax Expense
Profit After Tax (PAT)
Adjusted PAT (Excluding One-offs)
Profit Allocated to Non-Controlling Interest
🟩 Shareholder Metrics
Earnings Per Share (EPS)
Other Comprehensive Income (OCI)
📐 P&L Ratios
Gross Profit
EBITDA
EBIT
Net Profit Margin

8.5: Statement of Changes in Shareholders’ Equity

The Statement of Changes in Shareholders’ Equity (SOCSE) tracks all movements in a company’s equity during a financial year. It explains how the shareholders’ ownership value has changed due to profits, dividends, fresh issues, buybacks, or other items like revaluation gains and OCI.

🟩 Key Components of Shareholders’ Equity

  • Equity Share Capital: The base value of issued equity shares.
    Example: ₹500 Cr in Infosys equity shares.
  • Other Equity: Includes:
    • 🟢 Reserves & Surplus: Retained earnings (accumulated profits not yet distributed).
    • 🟢 Securities Premium: Amount received above face value of shares.
    • 🟢 General Reserve: Profits voluntarily set aside.
    • 🟢 Capital Redemption Reserve: Set aside during buybacks.
    • 🟢 Revaluation Reserve: Asset value adjustments due to revaluation.
  • Other Comprehensive Income (OCI): Unrealized gains/losses not part of PAT — e.g., forex changes, investment revaluation.
  • Non-Controlling Interest: Applicable in consolidated financials where subsidiaries are partially owned.

📋 Common Transactions That Affect Equity

  • 🟢 Net Profit: Increases retained earnings.
  • 🟥 Dividends Paid: Reduces retained earnings.
  • 🟢 Fresh Issue of Shares: Increases share capital and securities premium.
  • 🟥 Buyback of Shares: Reduces capital and creates capital redemption reserve.
  • 🟢 OCI Adjustments: May increase/decrease total equity.

📊 Example (Simplified)

Assume a company with:

  • Equity Capital: ₹100 Cr
  • Opening Retained Earnings: ₹400 Cr
  • Profit for FY23: ₹80 Cr
  • Dividend Paid: ₹20 Cr
  • OCI Gain: ₹5 Cr

Closing Equity = ₹100 + ₹(400 + 80 – 20) + ₹5 = ₹565 Cr

🎯 Analyst Tips

  • Track dividend policies and retained earnings trends to assess growth mindset.
  • Review fresh issue vs buyback history for capital allocation quality.
  • Ensure clarity between OCI and PAT — OCI gains are not realized yet.

8.6: Basics of Cash Flows

The Cash Flow Statement shows the actual movement of cash in and out of a business over a specific period. It is divided into three main parts: Operating, Investing, and Financing activities. It helps analysts understand how cash is generated and used across business functions.

💼 Operating Cash Flow (CFO)

This represents cash generated from the company’s core business operations.

  • 🟢 Includes: Net profit, adjustments for non-cash items like depreciation, changes in working capital.
  • 🟥 Excludes: Capital purchases, loan repayments, dividends.
  • Example: Infosys generated ₹21,000 Cr as operating cash in FY23.

Healthy CFO means the company can fund its operations, pay salaries, and handle short-term obligations using cash from its core business.

🏗️ Investing Cash Flow (CFI)

This reflects cash used in or generated from investments in long-term assets.

  • 🟥 Includes: Purchase/sale of PPE, purchase/sale of investments, business acquisitions.
  • 🟢 Negative CFI is normal for growing companies investing in expansion.
  • Example: Reliance spent ₹15,000 Cr on capex (Jio, Retail infra).

Check if investments are strategic (growth focused) or routine maintenance.

🏦 Financing Cash Flow (CFF)

This covers cash flows related to borrowing, repayments, and equity capital changes.

  • 🟢 Includes: Fresh equity issue, new loan raised.
  • 🟥 Includes: Dividend payout, debt repayments, buybacks.
  • Example: HDFC Bank repaid ₹5,000 Cr of long-term debt in FY23.

Net financing cash flow can indicate capital structure changes — check for recurring equity dilution or heavy debt repayments.

🎯 Analyst Tips

  • Consistent 🟢 positive operating cash flows = sustainable business.
  • 🟥 Negative investing cash flows = expansion (positive sign if revenue grows).
  • 🟩 Positive financing cash flow due to fresh capital/debt = check usage.
  • Use Free Cash Flow = CFO – Capex to judge surplus cash after investments.

8.7: Notes to Accounts

Notes to Accounts are an essential part of financial statements. They provide additional details and disclosures that help users interpret the financials better. These notes ensure transparency, compliance with accounting standards, and allow analysts to assess financial health beyond numbers alone.

8.7.1 📘 Significant Accounting Policies

These describe the principles, rules, and conventions followed by a company while preparing its financial statements. They ensure consistency and comparability year-on-year.

  • Revenue Recognition: When is revenue recorded? (e.g., at dispatch vs delivery)
  • Depreciation Method: Straight Line Method (SLM) vs Written Down Value (WDV)
  • Inventory Valuation: FIFO, Weighted Average, or NRV
  • Lease Accounting: As per Ind-AS 116 — right-of-use model
  • Foreign Currency Transactions: Conversion and recognition policies

Example: Infosys follows SLM for depreciation and recognizes revenue when performance obligations are satisfied.

8.7.2 ⚠️ Contingent Liabilities

Contingent liabilities are potential obligations that may arise depending on the outcome of future events. These are not recorded in the balance sheet but are disclosed in the notes as they involve uncertainty.

  • Litigations: Tax disputes, legal cases pending in courts
  • Bank Guarantees: Given to vendors, customers, or government
  • Corporate Guarantees: Provided to group companies or associates
  • Claims not acknowledged as debt: Disputed supplier or customer claims

Example: A company may disclose ₹500 Cr of income tax demand under dispute — not yet recorded as a liability.

🎯 Analyst Tips

  • Review notes on revenue, depreciation, and inventory — they affect margin analysis.
  • Look for large contingent liabilities that may later become actual liabilities.
  • Inconsistent accounting policies across years or with peers = red flag.
  • Cross-check related party disclosures in the notes for potential governance risks.

8.8: Important Points to Keep in Mind While Looking at Financials

Financial statements are a foundation for any business analysis. But numbers alone don’t tell the full story — analysts must look deeper into how figures change over time, compare with peers, and identify signs of risk or manipulation. Here are key areas to focus on:

📈 Profitability Checks

  • 🟢 Check if revenue and PAT are growing consistently over 3–5 years.
  • 🟢 Stable or improving margins = strong operations.
  • 🟥 Sudden rise in “Other Income” — may indicate non-operating dependence.

Example: If EBITDA margin drops YoY while revenue rises — investigate rising costs.

💰 Cash Flow vs Profit Consistency

  • 🟢 Operating Cash Flow (CFO) should be aligned with reported PAT.
  • 🟥 Profits without cash = possible receivable buildup or earnings manipulation.

Example: Company shows ₹500 Cr profit, but CFO is negative — verify if it’s due to WC changes or accounting tricks.

📦 Working Capital Movement

  • 🟥 Sharp rise in receivables or inventory = pressure on liquidity.
  • 🟢 Stable payables + healthy cash balance = good cash discipline.

Tip: Use Current Ratio and Quick Ratio for better clarity on short-term risk.

📊 Leverage and Debt Management

  • 🟥 High debt-to-equity (>1) in non-capex-heavy businesses = stress indicator.
  • 🟢 Declining finance costs over time = better debt management or refinancing.
  • Check if interest coverage ratio > 2 — ensures safety cushion.

Example: Compare Tata Motors vs Maruti — one is debt-heavy, the other debt-free.

📋 Accounting Consistency & Transparency

  • Check if depreciation method, revenue recognition policies change year-to-year.
  • Compare accounting practices with peers — deviation without reason = red flag.
  • Read audit notes and qualifications — even a “clean” report may include important observations.

🎯 Analyst Tips

  • Always analyze 3–5 years of financials — not just one year.
  • Use peer comparison and ratio analysis side-by-side with absolute figures.
  • Focus on cash flow trends, not just reported profits.
  • Flag any items that show unusual volatility: margins, debt, inventory, other income.

8.9: Reading Audit Report to Understand the Quality of Accounting

 

The audit report is a key document attached to the financial statements. It reflects an independent auditor’s opinion on the fairness, accuracy, and compliance of the company’s accounts with applicable standards. A “clean” audit opinion does not always mean everything is perfect — analysts must still read the report for signs of concern or qualification.

📑 Types of Auditor Opinions

  • 🟢 Unqualified (Clean) Opinion: Financial statements are true, fair, and comply with standards. Most listed companies aim for this.
  • 🟡 Qualified Opinion: Minor exceptions noted — could affect a specific area (e.g., inventory, tax, valuation).
  • 🔴 Adverse Opinion: Financial statements do not reflect fair view — serious issues in reporting.
  • 🔴 Disclaimer of Opinion: Auditor couldn’t obtain sufficient information — very high risk.

🔍 Key Audit Matters (KAMs)

Listed companies must disclose “Key Audit Matters” — complex or subjective areas auditors focused on:

  • Revenue recognition methods (timing, judgment)
  • Goodwill impairment and valuation assumptions
  • Tax litigations or contingent liabilities
  • Inventory obsolescence or fair valuation techniques

Tip: Review KAMs for high-risk areas — check if similar issues repeat every year.

🚩 Red Flags in Audit Reports

  • Auditor resignation or rotation just before financial year-end
  • Emphasis of Matter: highlights something serious, even under a clean opinion
  • Ongoing investigations or fraud-related notes
  • Repeated qualifications year after year
  • Delays in publishing financial results

📊 Example

Satyam (2008): Auditors failed to detect revenue inflation & cash manipulation. Reading audit qualifications could have alerted analysts earlier.

Modern Practice: Infosys and TCS publish detailed KAMs covering risk areas like client billing, project delivery, and tax exposures.

🎯 Analyst Checklist

  • 🟢 Read KAMs thoroughly for risk-prone areas.
  • 🟢 Check for consistency between auditor commentary and management claims.
  • 🟥 Be cautious of qualified/adverse/disclaimer opinions.
  • 🟥 Investigate emphasis of matter paragraphs and footnotes carefully.
  • 🟢 Match audit disclosures with notes to accounts and cash flows for triangulation.

8.10 & 8.11: Financial Ratio Analysis

Financial ratios help decode the deeper meaning behind numbers. Whether evaluating profitability, efficiency, leverage, or liquidity, these ratios provide clarity and comparability across time and industry.

📈 Profitability Ratios

Gross Profit Margin

Formula: (Revenue – COGS) / Revenue

Use: Measures production profitability.

Example: Nestlé India reported ~55% GPM in FY23.

Operating Margin (EBITDA Margin)

Formula: EBITDA / Revenue

Use: Evaluates core operating profit.

Example: Infosys ~25% EBITDA margin in FY23.

Net Profit Margin

Formula: PAT / Revenue

Use: Shows how much profit remains after all costs.

Example: TCS net margin ~21% – strong for IT.

💰 Return Ratios

Return on Equity (ROE)

Formula: PAT / Shareholders’ Equity

Use: Measures profit earned on capital invested by shareholders.

Example: HDFC Bank has ~17% ROE in FY23.

Return on Capital Employed (ROCE)

Formula: EBIT / Capital Employed

Use: Indicates efficiency of total capital usage.

Example: Asian Paints ROCE > 25%.

🏦 Leverage Ratios

Debt-to-Equity Ratio

Formula: Total Debt / Shareholders’ Equity

Use: Measures financial risk from borrowed capital.

Example: Tata Steel = 0.7 | Infosys = 0 (debt-free).

Interest Coverage Ratio (ICR)

Formula: EBIT / Finance Costs

Use: Measures ability to pay interest obligations.

Example: NTPC ICR = 3.2 – healthy coverage.

💧 Liquidity Ratios

Current Ratio

Formula: Current Assets / Current Liabilities

Use: Indicates short-term solvency.

Example: Marico has ~1.8 – good liquidity.

Quick Ratio

Formula: (Current Assets – Inventory) / Current Liabilities

Use: More conservative liquidity test.

Example: Titan ~1.2 – comfortably liquid.

⚙️ Efficiency Ratios

Inventory Turnover

Formula: COGS / Avg Inventory

Use: Measures how fast inventory moves.

Example: DMart = 12x – high efficiency.

Asset Turnover

Formula: Revenue / Total Assets

Use: Measures use of assets to generate sales.

Example: Reliance ~1.1x – efficient despite scale.

Receivables Turnover

Formula: Revenue / Avg Receivables

Use: Measures collection speed.

Example: Infosys ~6x – fast billing and recovery.

🎯 Analyst Tips

  • Use peer benchmarks for each ratio to assess performance.
  • Compare 3–5 years to see improvement or decline trends.
  • Be cautious of high margins with falling efficiency or debt spikes.

8.12: DuPont Analysis

 

DuPont Analysis is a powerful technique to break down Return on Equity (ROE) into three components: profitability, efficiency, and leverage. It allows analysts to understand the true drivers of shareholder returns and evaluate whether high ROE is sustainable or driven by excessive debt.

📘 DuPont 3-Step Formula

ROE = Net Profit Margin × Asset Turnover × Equity Multiplier

  • 🟢 Net Profit Margin = PAT / Revenue → Profitability
  • 🟢 Asset Turnover = Revenue / Total Assets → Operational Efficiency
  • 🟢 Equity Multiplier = Total Assets / Shareholders’ Equity → Leverage

Net Profit Margin

Shows how much profit is earned per rupee of sales.

Example: TCS PAT margin = 21% (FY23)

Asset Turnover Ratio

Measures how efficiently assets are used to generate revenue.

Example: Reliance = 1.1x

Equity Multiplier

Shows how much of the company’s assets are financed by equity.

Example: High multiplier = high leverage.

📊 Example Calculation

Assume a company has:

  • Net Profit = ₹120 Cr
  • Revenue = ₹1,000 Cr
  • Total Assets = ₹800 Cr
  • Equity = ₹400 Cr

Step 1: Net Profit Margin = 120 / 1,000 = 12%
Step 2: Asset Turnover = 1,000 / 800 = 1.25x
Step 3: Equity Multiplier = 800 / 400 = 2x

ROE = 12% × 1.25 × 2 = 30%

8.13: Forecasting Using Ratio Analysis

Ratio analysis isn’t just for reviewing the past — it also helps in forecasting future performance. By using key financial ratios such as margins, asset turnover, growth rates, and return metrics, analysts can project a company’s future revenue, expenses, profits, and capital needs.

📐 Common Ratios Used for Forecasting

  • 📈 Revenue Growth Rate: Past CAGR used to estimate top-line growth.
  • 📊 EBITDA Margin: Used to forecast future operating profits.
  • 💰 Net Profit Margin: Helps in estimating bottom-line earnings.
  • ⚙️ Asset Turnover Ratio: Used to estimate future asset needs based on revenue.
  • 📦 Working Capital Ratios: Helps determine short-term funding requirements.

📊 Example: Projecting FY24 Using FY23 Ratios

Assume:

  • FY23 Revenue = ₹1,000 Cr
  • Expected Revenue Growth = 12%
  • EBITDA Margin = 20%
  • Net Profit Margin = 12%

Forecast for FY24:

  • Revenue = ₹1,000 Cr × 1.12 = ₹1,120 Cr
  • EBITDA = ₹1,120 Cr × 20% = ₹224 Cr
  • Net Profit = ₹1,120 Cr × 12% = ₹134.4 Cr

🔍 Forecasting Insights

  • Use industry averages or peer trends when historical ratios are volatile.
  • Apply scenario analysis — base, optimistic, and pessimistic — using different ratios.
  • Link asset turnover to Capex planning — if sales rise, do assets need to rise too?
  • Forecast debt and interest expense based on leverage and coverage ratios.

8.14: Peer Comparison

Peer comparison helps analysts evaluate a company’s performance relative to its competitors in the same industry. It enables benchmarking of financial metrics, valuation, growth, and efficiency to identify leaders, laggards, and fair value.

📊 Key Metrics for Peer Comparison

  • Revenue Growth: Tracks market expansion or contraction
  • EBITDA & Net Profit Margins: Profitability comparison
  • ROE / ROCE: Return efficiency on equity and capital
  • Debt-to-Equity & ICR: Financial stability and leverage
  • Valuation Ratios: P/E, P/B, EV/EBITDA, Price/Sales

🧮 Example: IT Sector Peer Comparison (FY23)

Metric TCS Infosys HCL Tech
Revenue (₹ Cr) 2,25,458 1,46,767 1,02,784
EBITDA Margin 25.0% 21.5% 22.0%
Net Profit Margin 20.8% 16.0% 14.2%
ROE 47% 31% 24%
P/E Ratio 29x 25x 21x
EV/EBITDA 19x 16x 14x
Dividend Payout 85% 70% 60%

🎯 Analyst Tips

  • Compare peers in the same industry segment (large-cap vs large-cap, not SME vs leader).
  • Look beyond absolute numbers — margins and return ratios tell the real story.
  • Valuation multiples (like P/E) make more sense when normalized with ROE or growth.
  • Don’t ignore consistency — a company with slightly lower growth but high consistency is more reliable.

8.15: Other Aspects to Study from Financial Reports

 

While financial ratios and statements are critical, investors and analysts must also consider additional information provided in annual reports and disclosures. These factors offer deeper insight into the company’s behavior, shareholder returns, and promoter confidence over time.

📈 History of Equity Expansion

Analyzing how the company’s equity base has changed helps understand dilution risk and capital structure decisions.

  • 🟢 Check if the company raised capital frequently through fresh issues or rights issues.
  • 🟥 Frequent equity dilution without meaningful revenue/profit growth is a red flag.
  • Example: Startups often expand equity during early stages, but consistent dilution in later years needs scrutiny.

💰 Dividend and Earnings History

Steady dividend payout and consistent earnings indicate stable operations and cash flow strength.

  • 🟢 Look for consistent dividend payout ratio over 3–5 years.
  • 🟢 Rising EPS with matching dividend growth reflects shareholder-friendly policy.
  • Example: HUL and Infosys have strong dividend histories aligned with stable earnings growth.

📦 History of Corporate Actions

Corporate actions like stock splits, bonuses, rights issues, and buybacks affect capital structure and investor returns.

  • 🟢 Bonus and stock splits are neutral economically but can improve liquidity.
  • 🟢 Buybacks signal promoter confidence if done at fair price.
  • 🟥 Frequent rights issues or preferential allotments to insiders may indicate capital pressure.
  • Example: TCS has used buybacks to return cash and reduce excess equity.

👥 Ownership and Insider Trading History

Promoter shareholding trends and insider trading activity give important signals about internal confidence.

  • 🟢 Rising promoter holding = confidence in business.
  • 🟥 Frequent promoter selling or pledging = watch carefully for liquidity stress.
  • Example: Regular open market purchases by promoters are usually positive.

🎯 Analyst Tips

  • Cross-check equity changes with ROE trends to see if dilution led to better returns.
  • Match dividend payout with free cash flow, not just PAT.
  • Check if insider trading matches management commentary — alignment builds trust.
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