Financial Analytics- peeping behind the numbers
Now assume the company is enjoying a competitive advantage or comes with new landscape such as Blue Ocean with a more than decent management who is driving the company. Question I always encountered how do I know numbers are stacking up, can I see them in financials? Financial analytics is also used for screening of stocks but that’s not something we are focussing today.
Financial analytics means we are trying to use the accounting numbers that is recorded and information that is available. The most popular financial analysis of course is common size balance sheet/PL, ratio analysis.
Answer is you can but before that few important category I use and before I get into financials:
Category 1 :A company with existing competition who has a customised or tailored value chain (please see various discussions above to know what is tailored value chain, a fit etc) the above normal earnings and equity value should have been start kicking.
Category 2: If a company is in process of tailoring the value chain, numbers may not reflect but there exist better ways of gauging the advantages to come. Many people call it as “emerging advantage”.
Category 3: Now a Blue Ocean type of company (more like a growth and new value proposition) where numbers may not tell you everything.
Category 4: Last category is a company who was enjoying competitive advantage and messed it up in middle (for whatever reasons like bad management) and now on a come back trail.
Second aspect is the objective of financial analytics:
- To see and feel numbers including balance sheet, earnings and cash justifying your hard work on business understanding and analysis of competitive advantage or a Blue Ocean.
- This one is dicey, to compare my company with similar companies where information is available (either listed or not). In realty no two companies are similar head to toe, very important to know the differences then.
- Next one compare my numbers with a industry metrics and benchmark.
Now the challenges and opportunities:
- Any standardised portal like Morning Star, Economic Times, Screener, Money control have ratios, and KPI calculated ready made.
- These tools compute based on standard programming, so if you want variables to be customised may not be possible. Except in Screener where you can create your own ratios using variables.
- Ratios themselves have no standard framework like GAAP (Generally Accepted Accounting Procedures). It is up to the user of these KPI to interpret for their own need. So ROA for IT company and ROA for infrastructure company are not comparable.
- The ratios are calculated using audited financial numbers, so accuracy and validity of numbers can be trusted to a large extent unlike when you pull consultant published industry metrics who doesn’t take any accountability.
- KPI’s are evolving with industry progress e.g. EBIDTA was not used few decades, even EVA etc. Expect the ground line to move again.
Let’s come to action, the financial analytics centres around :
- The profitability
- The growth
- Cash flow
- Financial health
- Efficiency
The Profitability
How much company is profitable? Is higher profit also means higher margins? Has the tax rate levelled? Has the profit resulted return to shareholders?
Although we would like to have 3 margins (namely Gross, Operating and Net margins) our financial doesn’t provide all of them ready made.
Our ground lines in financials looks like this:
- Profit before taxes
- Profit after taxes
Yes that’s it (not confusing with extra ordinary items). So only Net Margin can be calculated straight forward from published numbers (profit after tax divided by Revenue)
How do we know Gross margin and operating margin? And in first place why it is important to know?
When we take out cost of goods sold or services from revenue from operations we get gross profit. Gross profit divided by revenue gives us the gross margin. Cost of goods sold indicates the direct cost required to produce the goods or services. And this is not easy for any retail shareholder to calculate, this is why:
Not all costs can be easily identified as direct cost. Discretions are used including apportionment of costs between direct and indirect. Example a plant financial controller is considered as direct cost, well he does a lot of thing for head office as well.In service industry it’s more complex, everyone and anyone can theoretically prove they are directly attributable to producing cost of services.Google it, you will get plenty of examples further. In real life situation company maintains MIS which breaks down the goods and services into multiple variables like product costing, SBU accounting etc. Company is not obliged to disclose these informations.
Theoretically higher the gross margin company has better reserves to manage other costs and obligations. If a gross margin is falling you can increase either price or cut down cost.
Next operating margin, this is to gauge operational performance. Operational performance depends on nature of operational expenses which is required for operations. Now you can say are the direct costs above in gross margin not operational cost? No, these are costs which are not directly attributable to production e.g. Research, Sales & Marketing , Administration over heads etc. Operating margin how much we are making before financial and regulatory charges hits us i.e. from operations. If your gross margin is higher and operating margin is lower you need to manage operating expenses properly. This is a pure cost management, price increase is part of gross margin maintenance.
Do we get numbers ready made? No, Research is reported separately in directors report. Sales and marketing may include multiple cluster accounting heads. Further let us understand one more thing:
The capital expenditure is not charged to financials same year because the benefits from assets are expected more than financial period. So only we consider operating expenditures for both gross margin and net margin calculation. Operating expenses include depreciation which is an amount kept aside every year against wear and tear of asset. You can say maintenance capital expenditure. What about purchasing assets for business growth? We call the as Growth Capital expenditure, this is not part of margin calculation, of course depreciation chargeable would have been included in expenses.
Lastly net margin , this is what left out after paying everyone. This is owner’s money which can be utilised for paying dividends, retain for further growth etc. The net profit after tax is a resultant number, so we do not have classification issue like operating and gross margin. However Net profit margin tells confusing story always, when interest comes down net margin goes up. It’s not necessarily good for company, a leveraged company (who has taken loan) utilise the advantageous cost of capital for shareholder return. If loan is reducing and interest costs coming down possibly growth avenues are stagnant. Take another example, a favourable tax rate due to Govt’s incentivisation may be temporary which can inflate net margin.
How do we use these margins for analysis?
- Year to year comparison to say are we improving?
- Second comparing with similar company to see whether are we delivering superior margins?
- Third if industry has a benchmark like say 20% operating margin where are we?
Suppose we get a positive answer for all three above. What happens? Multiple answers can be there, keep 2 key things which can be used in valuation:
- Assets are superior which are delivering stellar results.
- Management has been excellent to manage cost and price
If by using asset at a cost of capital 10% I am able to generate 40% operating margin and 20% net margin consistently this is nothing but called as competitive advantage of company.
Note: Tax rate- if tax rates are lower for some reason then normalise profit to that extent.
Lets think how we can use the margins for category of companies:
Category 1: Numbers should be healthy while comparing to peers or benchmark. Even internally improving YOY.
Category 2: this type of companies spend big bucks for creating resources. They may not deliver good net margin due to high leverage, sales may not have kicked off. Comparison with peers is of little use as every emerging company would be at different stages.
Category 3: Blue ocean type of companies, they don’t care about what competition does as they are on their own territory. No point in comparing with others. Even if you are going to compare internally you need to be careful vis-a-vis their value innovation, the activities are always on move
Category 4: come back companies will throw up divergence. Meaning operating margin goes up due to freshness of assets where as net takes a hit as loans are still getting repaid.
Every margin improvement should result superior return for shareholder otherwise its meaning less, how do we measure?
Return on equity- this is the return for equity shareholders, in other words earnings divided by equity. Return can be attributed to superior margins, efficient utilisation of assets and cost of capital required to fund assets and resources.
Margin combined with asset utilisation is nothing but return on assets. This tells us how much we are squeezing asset to get earnings out of them. Now few of the between the lines here:
- A superior ROA with a lower depreciation can be dangerous as capital assets are not replaced in time.
- Similarly high ROA with lower tax rates which can be temporary.
- ROA for service industry can be subdued as intangible assets are floor to accounting book keeping. They are more supervisory and discretionary.
The second fire power comes from funding the asset or financial leverage. Cost of capital varies a lot depending nature of funding. For example shareholder’s fund doesn’t have a fixed cost, so if my balance sheet is 90% equity and 10% debt this can add superior returns. Also I am making 15% net margin on my product and cost of funding (loan) is only 10%. Every 5% minus taxes goes to owner.
Return on equity can be managed by delivering excellent operational management (ROA) or financial management (Financial Leverage).
Now few between the lines:
- Considering lower cost of capital for equity capital is some time questionable. Everyone invests with an aim for capital appreciation and dividend. Ignoring capital appreciation completely can be error prone and not close to ground realty.
- Loans incentivise (subsidised) will enjoy leverage temporarily.
Now put your category companies for own understanding.
Finally Return on Invested Capital (ROIC)- this was a magic ratio when Prof Porter highlighted ROIC is the best ratio to measure competitive advantage of company.
Its basically a measurement of return to those who provided capital, doesn’t matter equity, debt, bonds etc. As only operating profits neutralised with taxes is used it reflects the return that has come from operations than below the line items. Companies within a superior industry enjoy high ROIC. For companies with high capital base this is an effective indicator, in other way if ROIC is more than Cost of capital every pie goes to shareholder.
Will ROIC work for Blue Ocean company, yes it will but to the extent for internal comparison only!
Next lets focus on growth and cash flow.
Few suggested readings:
Five Successful Rules of Investing by Pat Dorsey
Financial Statement Analysis by Fernando Alvarez