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Investors are the major users of financial statement analysis. But it is not easy to evaluate financial statements to arrive at a decision on whether to invest in a company.
This article tries to demystify the inferences an investor can make about the overall financial performance of a company from its financial statements.
Net worth
The first thing to look for in the financials of a company is the trend in its owner’s equity or shareholders’ funds. Suppose there are two firms A and B.
A has seen its shareholders’ funds grow from Rs 100 crore to Rs 225 crore in two years. B has seen it grow from Rs 50 crore to Rs 80 crore.
Though both the companies show growth in their shareholders’ funds, we cannot conclude anything about the overall performance of a company.
This is because a company can increase its shareholders’ funds by issuing new equity shares or mobilising capital. It can also increase them by increasing retained profit. If in the above example, A saw reserves and surplus increase by Rs 25 crore and B by Rs 25 crore, the latter obviously is better.
Return on Equity
The Return on Equity (ROE) enables us to compare the overall performance of a group of companies. It is calculated by dividing the profits available for equity shareholders by total shareholders’ funds.
For instance, if a company’s profits after tax is Rs 50 crore and its shareholders’ funds at the beginning of the year is Rs 150 crore then its ROE is at 33.33 per cent.
Higher the ROE, better is the financial performance of a company.
Every company operating in the market aims to maximise its ROE. But how to do it is the million-dollar question.
Maximise Pre-Tax Profit Margin : It is possible for a company to maximise its pre-tax profit margin by increasing its pre-tax profits by a higher magnitude compared with the magnitude of increase in its sales number. This calls for superior revenue management and greater cost control.
Maximise Asset Turn : Asset turn is computed by dividing the amount of sales by the amount of total assets. Higher the asset turn, better is the asset utilisation by the company. Hence, it is possible to maximise the asset turn by using the available assets to generate more and more turnover. This means that assets should never be kept idle.
Maximise benefits from financial leverage : When a company mobilises funds by borrowing or issuing debt securities, it generates a positive impact in its income statement in the form of tax deduction for interest payments.
Therefore, it is required for a company to opt for financial leverage (usage of debt in its financial structure) to maximize its ROE. But if the company is incurring loss in a specific year, then financial leverage maximises the losses of the company as it has to pay the interest irrespective of its profitability condition.
Minimise tax by proper planning : If a company can plan its tax obligations properly by making use of all the tax deductions and allowances then it can maximise its ROE.
Thus, numbers per se do not reveal anything about a company’s financial performance. What matters is the ability to read behind the numbers at the time of making our mind to invest in a company.
(The author teaches accounting and finance courses at IIM, Ranchi.)
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