Test your stock investing knowledge using our innovative online calculator. It’s a test designed using 28 comprehensive questions. This interactive tool provides a personalized evaluation of your stock investing skills. From basic concepts to complex analysis, challenge yourself and receive a percentage score that reflects your expertise. You can use this calculator to quantify the extent of your knowledge of stocks.
In the dynamic world of stock investing, having a solid understanding of stocks and the market is essential. It will help to make informed investment decisions. That’s where online calculators like these play a crucial role.
These calculators provide individuals, like yourself, with a quantifiable measure of their stock investing knowledge. One of the primary reasons why such calculators are required is to evaluate the depth and breadth of one’s stock investing knowledge. They offer an opportunity for self-assessment, allowing individuals to gauge their expertise and identify areas where further learning and improvement is needed.
In the fast-paced and ever-evolving world of stock investing, knowledge is power. The importance of having a solid understanding of stocks, markets, and investment strategies cannot be overstated. It is the bedrock upon which successful investment decisions are made and can have a profound impact on one’s financial well-being.
Recognizing this significance, we present an article that delves into the realm of stock investing knowledge. We are also offering a unique tool to assess and quantify your understanding of stock investing: the StockInvest IQ calculator.
Through a series of carefully crafted questions, this calculator will assess your grasp of essential concepts, analytical techniques, and risk management strategies.
Stock investing is a popular and potentially lucrative way to grow wealth and achieve financial freedom. However, it requires a solid understanding of the basics. Careful consideration of the potential benefits and risks involved is also necessary.
Let’s explore the fundamentals of stock investing, including what stocks are and how they work.
Stock investing involves buying shares or ownership stakes in publicly traded companies. When you purchase a stock, you become a shareholder and have a claim on the company’s assets and earnings.
Stocks are typically traded on stock exchanges, such as the Bombay Stock Exchange (BSE) or National Stock Exchange (NSE). Here the buyers and sellers come together to execute transactions. Know more about the stock market from here.
The primary goal of stock investing is to generate a return on investment (ROI). This can occur in two ways. First is through capital appreciation, where the stock price increases over time. The second is through dividends, which are a portion of the company’s profits distributed to shareholders.
Investors choose to hold stocks for the long term. They aim to benefit from the company’s growth and increase in value. A few known investors are Warren Buffett, Peter Lynch, Late Rakesh Jhunjhunwala, etc. Check 5 Golden Rules of Stock Investing.
People can also engage in short-term trading to take advantage of price fluctuations. These people are called traders, they are not investors but speculators. Though it is also true that very trained speculators can also make money from stock trading.
It is also crucial to acknowledge the risks associated with stock investing.
Prices of most stocks remain very volatile. The price is influenced by various factors such as economic conditions, market sentiment, and company-specific events. There is always the possibility of making a loss in stock investing. If the company performs poorly or goes bankrupt, the risk of loss is very high. For such companies, the stock price can crash very fast.
Even surrounding conditions can influence the price of individual stocks. Like it happened during the subprime mortgage crisis (2008-09), Brexit, and Covid-19 (2020). Global factors can cause fluctuations that impact stock prices. The challenge is to learn to time the market which is really challenging task and for most people, it is also impossible.
Having a solid understanding of stock investing is paramount for individuals seeking to build long-term wealth. Knowledge is the foundation upon which successful investment decisions are made. It plays a pivotal role in shaping an investor’s journey.
Let’s delve into the significance of stock investing knowledge and how it can positively impact investors.
A key benefit of stock investing knowledge is the ability to analyze stocks effectively. Investors equipped with the necessary knowledge can read and interpret financial statements. This helps in the evaluation of the company’s fundamentals and in formulating key financial ratios.
It enables the person to make informed judgments about a company’s value, growth prospects, and financial health.
A deep understanding of fundamental analysis techniques equips investors to identify high-quality stocks and make sound investment decisions.
Stock investing knowledge empowers investors to spot investment opportunities that may be overlooked by others. It can be done by staying informed about market trends, industry developments, and emerging sectors.
This is the way knowledgeable investors can identify undervalued stocks or companies with strong growth potential.
This insight enables them to capitalize on market inefficiencies and potentially achieve superior investment returns.
The stock market is inherently unpredictable, and risks abound. However, investors armed with stock investing knowledge are better equipped to manage and mitigate these risks.
How to mitigate the risks? Through proper risk assessment, portfolio diversification, and an understanding of different investment strategies. This way, knowledgeable investors can construct a well-balanced portfolio that aligns with their risk tolerance and investment objectives.
Additionally, knowledge enables investors to identify warning signs and indicators of potential market downturns. It insight allows them to make informed decisions to protect their investments.
Stock investing knowledge is not static; it requires ongoing learning and adaptation. The market landscape evolves, new investment instruments emerge, and regulations change. Investors who prioritize knowledge are better prepared to adapt to these changes and refine their strategies as needed.
By staying informed through reading or seeking advice from professionals, investors can continually enhance their stock investing knowledge. This way they continually improve their decision-making abilities.
Knowledge enhancement is a must in stock investing. One cannot afford to cling only to the old theories and practices. Though the age-old value investing theories of Benjamin Graham is still relevant, new investing skills will assist further.
Enhancing stock investing knowledge is a continuous process that can significantly benefit investors in making informed decisions and achieving better investment outcomes.
In this section, we will explore some practical steps and recommend valuable resources to aid in your learning journey.
Refer to Online Portals: There are websites such as Investopedia and Morningstar that offer a vast array of articles, tutorials, and market analysis. Subscribe to their newsletters or follow their social media channels to receive updates. You can also follow this blog on Twitter and Telegram.
Use Online Tools: You can also use an online tool like our Stock Engine. It can help one to screen potential stocks and provide a report on individual stocks. It is basically a fundamental analysis tool. Apps like these provide updated information and analysis about stocks.
Continuous learning and practiceare key to improving stock investing knowledge. It’s important to apply what you learn. Try to do your own analysis and buy a stock. The whole process of analysis, buying, and holding will give you a different perspective of stock investing.
By taking the assessment, readers can gauge their understanding of various concepts and identify potential gaps in their knowledge. This self-assessment tool serves as a valuable starting point for further learning and growth.
“Pricing power is the ultimate business superpower. It allows companies to dictate their own terms, maintain healthy profit margins, and withstand competitive storms. Companies with pricing power are basically businesses with amonopoly status. Such companies display great brand strength to market dominance.”
In this article, we unravel the mysteries of pricing power. We’ll explore how it can make or break companies. We’ll discuss why investors and business owners alike should pay keen attention to this invaluable asset.
Pricing power refers to a company’s ability to adjust prices without a significant impact on demand. Such an action enables it to maintain higher profit margins and withstand competitive pressures. It ultimately drives long-term profitability. Hence, Understanding and assessing pricing power is crucial for investors and businesses.
“Unleashing the Power of Pricing: How Pricing Power Drives Business Success” is likely the title or topic of a book, article, or discussion that explores the critical role of pricing strategies in business success. While I don’t have access to specific content beyond my knowledge cutoff date in September 2021, I can provide you with a general overview of the concept and the importance of pricing power in business:
Pricing Power Definition: Pricing power refers to a business’s ability to set and maintain prices for its products or services at levels that are profitable and sustainable. A company with strong pricing power can influence and control pricing in its market, often due to factors such as brand strength, product differentiation, or a loyal customer base.
Profitability: Pricing power enables a business to charge higher prices for its products or services, resulting in increased profitability and revenue.
Competitive Advantage: Companies with pricing power can withstand competitive pressures and market fluctuations more effectively. They are less vulnerable to price wars and can maintain healthy profit margins.
Brand and Perceived Value: Strong brands and products with unique features or perceived high value often command higher prices. Customers are willing to pay more for products they perceive as superior.
Customer Loyalty: Building strong customer loyalty allows a company to maintain pricing power. Loyal customers are often less price-sensitive and more willing to pay premium prices.
Innovation: Continuously innovating and offering unique products or services can help a business establish and maintain pricing power. Customers are willing to pay more for innovative solutions.
Segmentation: Effective pricing strategies often involve segmenting the market and offering different price points for different customer segments. This allows a business to capture value from various customer groups.
Value-Based Pricing: Pricing based on the perceived value of a product or service to the customer is a powerful strategy. It aligns pricing with what customers are willing to pay.
Elasticity: Understanding price elasticity of demand (how sensitive customers are to price changes) is crucial. Businesses with pricing power can often raise prices without significant loss of sales volume.
Data and Analytics: Modern businesses leverage data and analytics to fine-tune their pricing strategies. This helps in optimizing prices for maximum profitability.
Ethical Considerations: While pricing power can lead to higher profits, businesses must also consider ethical implications and avoid price gouging or unfair practices.
In essence, the concept of pricing power underscores the importance of pricing as a strategic tool in business. When leveraged effectively, it can be a driver of long-term success by enhancing profitability, market position, and customer loyalty. Books, articles, and discussions on this topic often delve into case studies, real-world examples, and actionable strategies for businesses to develop and utilize pricing power to their advantage.
Warren Buffett, one of the most successful investors of all time and the chairman and CEO of Berkshire Hathaway, has frequently emphasized the importance of pricing power in his investment philosophy and business strategy. Here are some key insights and quotes from Warren Buffett regarding pricing power:
In this quote, Buffett highlights that a business with pricing power can increase prices and maintain or even grow its customer base, which is a sign of a strong and resilient business model.
Buffett’s ideal business is one that not only has pricing power but also can reinvest its profits at high returns. This combination leads to compounding growth in value over time.
Buffett emphasizes that a business’s ability to generate high returns on invested capital is a key factor in its long-term success. Pricing power plays a crucial role in achieving those high returns.
**”You want to be able to charge prices that reflect the value you’re providing. If you’ve got a good product or service and you’ve got the ability as a result of uniqueness or geographic location or whatever it may be to charge a price that is commensurate with the utility you’re giving people, you’re in a great position as a business.”
Buffett underscores that pricing should align with the value a business provides to its customers. If the product or service is valuable and unique, the business can command higher prices.
While not explicitly about pricing power, this quote highlights Buffett’s focus on identifying businesses with a sustainable competitive advantage. Pricing power often contributes to a company’s competitive advantage by allowing it to maintain superior profitability.
In summary, Warren Buffett recognizes the significance of pricing power in assessing the quality of a business and its potential for long-term success. A company with pricing power can maintain or increase prices while delivering value to customers, resulting in strong and enduring financial performance.
In that letter, he emphasized the significance of pricing power as a key factor in evaluating businesses. He highlighted its crucial role in determining a company’s competitive advantage and long-term profitability. Since then, Buffett has consistently referenced and emphasized the importance of pricing power in various shareholder letters, interviews, and public discussions on investing and business strategy.
Pricing power is a concept that encapsulates a company’s ability to set prices for its products or services, without resistance. Normal companies (with no pricing power) experience significant resistance when they try to hike prices. The price hikes impact customer demand.
Understanding and assessing pricing power is crucial for investors and businesses alike. It directly affects a company’s ability to generate sustainable profits, maintain market share, and withstand competitive pressures.
By identifying companies with strong pricing power, investors can make informed decisions to maximize potential returns. The businesses can also leverage this advantage to solidify their market position and drive long-term growth.
Market dominance plays a significant role in shaping the pricing power of companies. When a company holds a substantial market share, it often gains a greater ability to influence and control prices. Here are a few more factors that can influence the pricing power:
Unique Offering: Such companies often offer unique products or services. This is what gives them a dominant market position. Their ability to offer something unique allows them to ask for higher prices than their competition. The customers also pay a premium for the perceived value they receive.
Brand Loyalty: The pricing power is bolstered by strong brand recognition and customer loyalty. When customers associate a brand with quality or desirability, they are more likely to accept higher prices without seeking alternatives.
Monopoly Status: Such companies benefit from limited substitutes or alternatives available to customers. This situation gives a kind of monopoly status to companies. Hence, coherent price rises are often acceptable to the customers.
Dominant Player: They have more pricing power than competitors. Such companies create higher barriers to entry. The entry barrier is created by economies of scale, strong brand recognition, high customer switching costs, or established distribution networks.
Nonetheless, market dominance generally provides companies with a stronger position to dictate prices. These companies can also resist price pressure from competitors, and maintain their higher profit margins.
To develop and enhance pricing power, companies can employ several strategies. We’ll discuss some of them in this article. Though it is not an exclusive list this is what I’ve observed by looking at companies with pricing powers.
Differentiation and Value Proposition: Companies can develop pricing power by offering unique products or services. Feature-rich offering which is also of superior quality, or innovative is my first choice. For example, Apple Inc clearly delivers the value proposition through its products. This way it can differentiate itself from competitors and justify premium pricing.
Branding and Reputation Building: Building a strong brand and reputation establishes trust, credibility, and customer loyalty. It enables companies to command higher prices. Investing in brand-building activities, effective marketing campaigns, and consistent customer experiences can enhance pricing power. Again, Apple Inc has mastered the art of brand building.
Customer Relationship: Nurturing strong customer relationships is crucial for pricing power. Companies offering premium products backed by excellent service build strong brand loyalty. Loyal customers often resubscribe and are ready to pay increased prices if any.
Continuous Innovation: Investing in continuous innovation and product development helps companies stay ahead of the competition and maintain pricing power. By regularly introducing new features, improvements, or product lines, companies can justify premium pricing and avoid commoditization.
Operational Excellence and Cost Efficiency: Efficient operations and cost management contribute to pricing power. Companies that optimize their supply chain and have a streamlined process can practice higher pricing power. Companies that can leverage economies of scale can offer competitive prices and can still maintain profitability. The cost advantages provide flexibility in pricing decisions.
By implementing these strategies and continuously adapting to market conditions, companies can strengthen their pricing power.
Pricing power serves as a crucial driver of long-term success and resilience in the ever-evolving business landscape.
In the large-cap space, there are companies like Asian Paints, Nestle India, HUL, and Titan Company that display phenomenal pricing power.
But there are few companies from the mid and small-cap spacethat has displayed signs of pricing power.
Relaxo Footwear: As of June-2023, its market cap is about Rs.22,600 crore. It is a leading footwear company in India. It has a strong brand presence and reasonable product quality. The company has successfully established itself as a premium brand in the affordable and mid-price range footwear segment. Relaxo Footwear has been able to maintain higher price points compared to its competitors, reflecting its pricing power in the market. The company’s wide distribution network and market penetration have contributed to its pricing power. The P/E ratio of Relaxo is 144. Check its fundamentals here.
India Nippon Electricals: As of June-2023, its market cap is about Rs.1,020 crore. It is a leading manufacturer of ignition systems for automotive and general-purpose engines. In recent years, the company has been able to raise prices without losing too many customers. This is due to the high quality of its products and the lack of substitutes available in the market. The P/E ratio of India Nippon is 21.15. Check its fundamentals here.
Chemcon Speciality Chem: As of June-2023, its market cap is about Rs.1,017 crore. This company is a leading manufacturer of specialty chemicals. It has a strong brand reputation and a large market share in the domestic market. Over the last five years, the ROE and ROCE of the company have been trading above 15% and 20% levels respectively. The P/E ratio of Chemcon is 18.5. Check its fundamentals here.
Ksolves India. As of June-2023, its market cap is about Rs.1,065 crore. This company is a leading provider of IT solutions in India. In the last three years, the company is able to increase its ROE and ROCE at a dramatic pace. In the last three years, its operating revenue and net profit have increased by three folds. Though equity has also got diluted by almost 8 times.
Till the company is enjoying the pricing power, it looks invincible. But it must also be considered that no company can have the pricing power forever. There will be new companies coming in that will eventually break their economic moat.
Here are some key considerations:
The elasticity of Demand: Pricing power assumes that customers will accept higher prices without significantly reducing their demand. However, if the price increase is met with a more significant decline in demand than anticipated, it can result in lost sales and revenue. Companies need to carefully assess price sensitivity. Otherwise, if they overestimate their pricing power, they may end up losing their market share.
Competitive Pressure: Pricing power can be challenged by intense competition in the market. Competitors may respond to price increases by offering lower prices, promotional offers, or alternative products. This can erode a company’s pricing power and force them to adjust their pricing strategy to remain competitive.
Market Disruption and Technological Advances: Disruptive technologies or market shifts can quickly undermine pricing power. Companies that fail to adapt to changing market dynamics or technological advancements may find their pricing power diminished.
Regulatory and Legal Constraints: Pricing decisions may be subject to regulatory oversight or legal constraints. For example, companies operating in sectors like oil & gas, power, utilities, banking, Airlines, Telecom, etc can have only little or no pricing power.
Customer Perception and Brand Equity: Pricing power relies heavily on customer perception and the perceived value of a company’s products or services. If customers perceive a mismatch between the price and the value they receive, it can undermine pricing power. If customer trust and loyalty get eroded, pricing power will also vanish.
Economic Factors: Economic downturns, inflation, or changes in consumer purchasing power can impact pricing power. In times of economic or geo-political instability, companies find it hard to maintain their power of pricing.
Pricing power is a crucial aspect for investors to consider when evaluating potential investment opportunities. Companies with strong pricing power possess a unique advantage that allows them to command higher prices, maintain profit margins, and withstand competitive pressures.
Operating Profit Margin: This metric measures the profitability of a company’s core operations. A higher operating profit margin (OPM) implies that the company has effective cost management. A consistently high OPM suggests that the company has pricing power.
Relative Margins & Revenue: Comparing a company’s GPM and OPM with its peers can build a strong impression of the company’s pricing power. If the margins of the company are growing at a rate faster than its peers, it is a big advantage. But while making this analysis, it is also essential to look at operating revenue growth. If the revenue is also growing faster than the peers, it is a clear sign of pricing power.
Companies with strong pricing power can command higher prices, maintain profit margins, and withstand competition. By identifying companies with high pricing power, investors can make informed investment decisions. This way they can benefit from their sustained profitability and competitive advantage.
Income and wealth are two distinct concepts in personal finance. Income refers to the money earned regularly, while wealth represents the accumulated assets and net worth. Understanding the difference between income and wealth is vital for effective financial planning. It guides budgeting, investment decisions, and long-term wealth-building strategies.
When it comes to personal finance, the terms “income” and “wealth” are often used interchangeably. However, they represent distinct concepts that play a crucial role in one’s financial journey. Income refers to the money earned regularly, whether through employment, investments, or other sources. On the other hand, wealth encompasses the accumulated assets and net worth of an individual or entity.
Differentiating between income and wealth is important. It helps individuals understand their financial situation more accurately and make informed decisions.
Many people mistakenly assume that a high salary automatically translates into high wealth. However, this is not always the case. Here’s why:
Expenses and Lifestyle: A high-salary earner may have significant expenses and a lavish lifestyle. Such a lifestyle is supported by their high income. A significant portion of their income goes towards maintaining their lifestyle. As a result, they may end up saving and investing less. Only significant investments can lead to wealth creation.
Overspending Using Debt: Some high-salary earners may carry significant loans. Why? Because they can afford to pay the monthly EMIs. They wrongly correlate their EMI paying ability with their affordability. Suppose, my monthly salary is such that I can easily pay one lakh in EMI. As a result, I will assume that I can easily buy a home worth one crore (assuming, a 1 Crore loan = 1 lakh EMI). But in reality, my bank balance was only five lakhs. It means, what I’m assuming is affordable is a fallacy.
[P.Note: Individuals with moderate incomes can accumulate significant wealth. If they practice diligent saving, make wise investment choices, and manage their expenses effectively, they can also become wealthy. Wealth is built over time through a combination of income, savings, investment growth, and debt management.]
The Definition of “Wealthy” in India
I have a theory that I use to distinguish a normal person from a wealthy person.
As per data published by the World of Statistics, on average, professionals in Indiaearn an income of about Rs.46,900 per month. We’ll use this figure as our basis to define who is wealthy in India. Please note that I’m assuming Rs.46,900 as the net take-home salary and not the CTC (Cost to the Company). It means Rs.46,900 is the amount that gets credited to one’s bank account each month.
Let’s define the minimum characteristics of a wealthy Indian person. A person who is starting to show these first characteristics is beginning to become wealthy.
Characteristic #1 (Earned Income): The minimum earned income of the person should be at least two times the average world data (Rs.46,900). It means, if the person is earning an average take-home salary ofabout Rs.95,000 per month, he is satisfying the first parameter of being wealthy. Please note that by earned income I mean income from job, business, etc.
Characteristic #2 (Passive Income): The minimum passive income of the person should be at least equal to the average world data (Rs.46,900). It means, the person must have an investment portfolio that consists of enough passive-income-generating assets. Assuming an income yield of 6.5% per annum, the size of the asset base should be at least Rs.87,00,000. To know the difference between earned income and passive income, read this article.
Characteristic #3 (Growth Portfolio): There are two components of an investment portfolio. The first takes care of the passive income (#2 above). The second takes care of the necessary growth that makes a person wealthier time after time. The minimum size of this growth portfolio should be at least 50% of the passive income portfolio. As we’ve fixed the minimum asset base in #2 as Rs.87 lakhs, the minimum size of the growth portfolio isRs.45,00,000.
Who can be called as wealthy in India? A person is wealthy if he/she is showing at least these two characteristics in tandem. First, his/her investment portfolio size is at least Rs.1.3 crore. Second, his monthly earned income is at least Rs.95,000 per month.
So, taking this as our basis for being wealthy, let’s try to answer a tricky question.
Suppose there is a fresh graduate (Mr.ABC) whose starting salary is Rs.4,00,000 per month. Can he be treated as a wealthy individual? As we have already seen, to become wealthy, the person must fulfill the following four characteristics.
But a high monthly income can assist in building the required investment portfolio faster. Such a person can also buy a small home as per his affordability very early in life. This way, his path to a wealthy life becomes a tad bit easier.
But I would like to clarify a point here. Here, the above explanation may give the impression that a high paycheck is the only key requirement to becoming wealthy faster. A higher paycheck is certainly helpful, but it does not mean that people with lower incomes cannot become wealthy.
How lower-income people can become wealthy?
Here is an example of two people. First is the high-earning person who makes about Rs. 4 Lakhs per month income. Second is a normal average person who earns an income of about Rs.1 Lakhs per month.
Let’s study these two individual’s investing habits and how it accounts for their long term wealth creation.
High Income (Rs.4 Lakhs / Month): The person invests about Rs.1.5 Lakhs per month. As he is not very conversant with investments, he found it better to invest in a diversified equity mutual fund through the SIP route. This mutual fund scheme yielded a return of close to 16% per annum in 15 years. At the end of the 15th year, he built a corpus of about Rs.11.2 Crores.
Average Income (Rs.1 Lakhs / Month): The person invests about Rs.15,000 per month. The person is conversant with investments, hence he invested directly in quality shares. As this person was wiser in investing, he also started investing five years early than his peer. He very carefully built his stock portfolio which yielded him a return close to 26% per annum in 20 years. At the end of the 20th year, he built a corpus of about Rs.12.0 Crores. Read: Test your knowledge of stocks.
The idea is to use one’s intelligence and knowledge to identify quality stocks. Investing one’s money into such stocks and staying invested for the long term can help one become wealthy over time.
Out of all people in a nation, only a handful of people are rich.
In order to judge how wealthy is a person, we can use this scale to judge the degree of wealth one has accumulated. What is the requirement to be tagged as wealthy? Check here.
Grade 0 – Not meeting the criteria
Grade C – Just Rich (Just meeting the criteria).
Grade B – Moderately Rich (Income and Assets at least 10 times the requirement).
Grade A – Really Rich (Income and Assets at least 50 times the requirement).
Grade A+ – Filthy Rich (Income and Assets at least 100 times the requirement).
While income is important for meeting day-to-day expenses and maintaining a comfortable lifestyle, wealth is more stable and accumulative in nature.
Differentiating between income and wealth is essential to avoid common misconceptions. Simply having a high salary does not guarantee wealth, as expenses, lifestyle choices, and debt can hinder wealth creation. There are people who earn a very high salary but spends all if it on needless things. Such people have no spare money for investment and wealth creation.
It is important to manage expenses effectively, make wise investment choices, and practice diligently saving to build wealth over time.
Moreover, it is essential to recognize that wealth can be achieved by individuals with moderate incomes as well. By making informed financial decisions, focusing on savings, and investing wisely, anyone can accumulate significant wealth.
Higher income can facilitate wealth creation, it is not the sole determining factor. Even individuals with lower incomes can become wealthy by leveraging their investing skills, making informed investment choices, and focusing on long-term growth.
A common misunderstanding between credit and debt is that they are often used interchangeably or considered synonymous. While they are closely related concepts, they have distinct meanings and implications. This article will use examples to explain the difference between credit and debt
Equating credit with debt: Some people mistakenly believe that credit itself is the debt. However, credit refers to the trust or borrowing capacity extended to individuals or entities. Whereas, debt represents the actual financial obligation resulting from utilizing that credit.
Credit is a negative aspect of financial management: Some individuals associate credit with excessive borrowing or being in debt. However, credit, when used responsibly, can be a valuable tool for facilitating economic activities. It is the misuse or mismanagement of credit that can lead to overwhelming debt and financial difficulties.
Being debt-free will get a good credit score: While minimizing debt is generally advisable. But having no credit history can be as damaging as a high debt burden. In a way, credit is an unavoidable requirement for the majority. Keeping oneself creditworthy is also necessary.
The incorrect definition fails to capture the essential aspect of credit, which is the extension of trust and the ability to access funds or goods based on that trust. It wrongly emphasizes the owed amount rather than focusing on the concept of financial trust and the borrowing capacity that credit represents.
Remember, credit is not about the amount owed but rather theability to borrow or accessfunds based on one’s creditworthiness. It’s crucial to understand this distinction to have a clear understanding of credit and its role in financial transactions.
Before we proceed to see the examples, another small clarification about debt.
The other forms of debt borrowing can also arise from other forms of credit, such as credit cards, lines of credit, mortgages, personal loans, or borrowing from individuals, etc.
Imagine you are a member of a community-based library. The library allows its members to borrow books for a certain period. Here’s how credit and debt come into play in this scenario:
As a member of the library, you have access to credit in the form of borrowing books. The library extends credit to you, allowing you to take books home without upfront payment. This credit represents the trust placed in you as a member to borrow books and return them within the specified borrowing period.
When you borrow a book from the library, you incur a debt to the library. This debt represents your obligation to return the book within the agreed-upon timeframe. Until you return the book, you have a debt to the library for that specific item. Once you return the book in good condition, your debt to the library is settled.
Imagine you want to purchase a new smartphone worth ₹50,000, but you don’t have enough money to pay for it upfront. Here’s how credit and debt come into play:
After making the purchase using your credit card, you now have a debt of ₹50,000. This debt is the financial obligation you owe to the credit card company. It represents the amount you borrowed to buy the smartphone. You will need to repay this debt according to the terms and conditions set by the credit card company. If you don’t pay off the debt promptly, it may accrue interest charges, making the total amount owed higher over time.
It’s important to note that credit and debt are intertwined. How? Because credit enables you to incur debt. But it is essential to remember that they are distinct concepts. Credit represents the ability to borrow or access funds, while debt represents the actual obligation resulting from borrowing.
Suppose you are looking to purchase a car worth ₹5,00,000, but you don’t have enough money to buy it outright. Here’s how credit and debt come into play in this scenario:
You approach a bank or a financial institution for a car loan. After reviewing your creditworthiness, income, and other factors, the bank approves your loan application. The bank extends credit to you by granting you a loan of ₹5,00,000. This credit represents the financial trust placed in you to borrow the required amount to purchase the car.
With the approval and disbursement of the loan, you now have a debt of ₹5,00,000. This debt is the financial obligation you owe to the bank. It represents the actual amount borrowed to buy the car. You enter into a loan agreement with the bank, which outlines the repayment terms, including the interest rate, monthly installments, and the duration of the loan. You will need to make regular payments to the bank over the agreed-upon period to repay the debt.
In this example, credit is the financial trust extended to you by the bank, allowing you to borrow the necessary funds to purchase the car. Debt, on the other hand, is the specific amount you owe to the bank as a result of taking the loan. The credit enables you to acquire the car, while the debt is the subsequent financial obligation that arises from borrowing.
After receiving the raw materials on credit, you now have a debt of ₹50,000 to the supplier. This debt represents the financial obligation you owe to the supplier for the materials you received. It signifies the actual amount you borrowed from the supplier to fulfill your business needs. You are now responsible for repaying this debt to the supplier as per the agreed-upon terms, which may include a specific repayment period or payment schedule.
Let’s say you are a freelance coder, and you receive a request from a new client to write a code for their mobile app. The client agrees to pay you ₹20,000 for your services upon completion of the project. Here’s how credit and debt come into play in this scenario:
In this example, credit is the trust placed in you by the client, allowing you to begin the project without receiving payment upfront. Debt, in turn, represents the specific obligation you owe to the client to write the complete the code as agreed. The credit enables you to initiate the project, while the debt represents the subsequent responsibility to fulfill your part of the agreement.
Credit utilization refers to the percentage of your available credit that you are currently using. It is an important factor that impacts your credit score. Let’s consider an example to understand this concept:
A lower credit utilization percentage is generally considered better for your credit score. It indicates that you are not heavily reliant on credit and are managing your debt responsibly. Lenders and credit rating agencies often view lower credit utilization as a sign of good financial management.
Even though both individuals have the same credit limit, Person B has a lower credit utilization, which is more favorable from a credit scoring perspective.
Managing your credit utilization by keeping it low demonstrates responsible credit usage and can positively impact your credit score. It’s generally recommended to aim for a credit utilization rate below 30% to maintain a healthy credit profile.
Remember, credit utilization is just one aspect of credit and debt management, but it can have a significant impact on your creditworthiness and financial well-being.
Here’s a summary of the difference between credit and debt in a tabulated form based on the examples provided:
Examples
Credit
Debt
Example #1: Day-to-Day Life
Borrowing books without upfront payment
Obligation to return borrowed books
Example #2: Credit Card
Accessing credit limit to make a purchase
The specific amount owed to the lender
Example #3: Car Loan
Loan granted to purchase a car
The loan amount disbursed to the borrower
Example #4: Business Purchase
Supply of the raw material without upfront payment
Payment to be made to the supplier
Example #5: Business Sale
The order received from the client is the credit
The Delivery of the complete codes
In each example, credit represents the trust extended or borrowing facility provided, enabling individuals or businesses to access funds, goods, or services. Debt, on the other hand, represents the actual financial obligation resulting from utilizing that credit, indicating the specific amount owed and the responsibility to repay or fulfill the borrowed obligations.
The examples we have examined, whether it’s using a credit card for a purchase, obtaining a car loan, engaging in business transactions, or even borrowing books from a library, demonstrate how credit and debt operate in diverse contexts. They showcase the interplay between credit, which allows individuals or businesses to access resources, and debt, which represents the subsequent responsibility to repay or fulfill the borrowed obligations.
Credit and debt are intertwined but distinct concepts. They play significant roles in personal and business finances, and understanding their implications is key to achieving financial stability and building a strong credit foundation.
Being inspired by the legendary investor Peter Lynch’s investment philosophy, GARP investing combines the best of both growth and value investing. Its aim is to identify companies with strong growth potential at a reasonable valuation.
GARP investing can be defined as an investment approach that seeks to identify companies with robust growth prospects while considering their valuation.
To understand the philosophy behind GARP investing, we turn to Peter Lynch, the renowned investor and former manager of Fidelity Magellan Fund.
Lynch believed in the long-term growth potential of select companies. He emphasized the importance of investing in companies with solid fundamentals. By solid fundamentals, Lynch includes factors like consistent earnings growth, increasing sales figures, and significant market potential.
By focusing on companies with such qualities, Lynch aimed to capitalize on their growth trajectory while maintaining a disciplined approach to valuation.
Assessing a company’s growth potential is a crucial aspect of GARP investing. Historical and projected growth rates are key indicators to consider.
Examining a company’s past performance can provide insights into its ability to generate consistent growth. Additionally, analyzing industry trends and market conditions can help identify sectors with potential for sustained growth.
For example, in the Indian stock market, one such company that demonstrated strong growth potential in recent years is HDFC Bank. With consistent growth in its earnings and an expanding customer base, the bank established itself as a leading player in the Indian banking sector.
Going forward in the year 2023, Indian industries that come under the bigger umbrella of the manufacturing sector look promising. Quality companies operating in the industries like defense, electronic manufacturing, healthcare, renewable energy, logistics, agriculture, etc can see robust growth.
Several factors play a role in evaluating a company’s growth potential. GARP investors consider a company’s competitive advantage, market share, and product differentiation.
A strong competitive position can allow a company to capture market opportunities and maintain its growth trajectory.
For investors like us, the way to forecast future earnings growth rates is to look into the past. We can look at their PAT and EPS numbers in unison.
Note the last 10 years’ PAT and EPS numbers of the company. Plot a line chart for both of them to get a visual trend.
GARP can refer to several different things depending on the context. Here are a few common meanings:
Global Association of Risk Professionals (GARP): GARP is a non-profit organization that focuses on risk management education and certification. It is known for its Financial Risk Manager (FRM) certification program, which is widely recognized in the finance industry. GARP provides resources, research, and a professional network for risk management practitioners.
Generally Accepted Recordkeeping Principles (GARP): GARP is a framework developed by ARMA International (formerly known as the Association of Records Managers and Administrators) to establish guidelines and best practices for effective information and records management within organizations. It outlines principles and standards for the creation, maintenance, and disposition of records.
Glycine Amidinotransferase Reductase Protein (GARP): GARP is a protein that plays a role in various biological processes, including the regulation of immune responses and the development of certain cells. It is involved in T-cell biology and has implications in immune-related diseases.
Generalized Axiomatic Resource Profile (GARP): GARP is a term used in the context of resource allocation and optimization in computer science and network management. It refers to a set of principles or rules that guide how resources are allocated and managed in a system to achieve specific objectives efficiently.
To quantify the trend. We can also calculate the last 10-Yr, 7-Yr, 5-Yr, and 3-Yr growth rates, for both PAT and EPS. The Growth rate (CAGR) formula to be used for calculation is shown below.
Now, compare the PAT and EPS growth numbers.
PAT
EPS
10-Yr Gr.
10.9%
4.1%
7-Yr Gr.
4.86%
-1.60%
5-Yr Gr.
2.73%
-3.54%
3-Yr Gr.
0.29%
0.44%
Digging into the PAT and EPS Growth Rates
Compare the PAT and EPS growth rates. If they are growing at the same pace in all years, it is an ideal growth story.
Explanation (difference in PAT and EPS growth rates)
For some stocks, the PAT growth rate will be higher than EPS growth. It is a situation that will happen only if the company has raised funds by issuing more shares. The number of shares outstanding for such companies grows with time. This in turn reduces the EPS numbers. As an investor, we want outstanding shares to remain constant or better reduce in numbers (shares buyback).
If PAT is growing at a negative rate, then EPS will also show a negative growth rate. Companies showing such characteristics are avoidable.
Note: You can see in the above table, our example stock’s PAT has grown at a slow pace in the last 10 years. But its EPS numbers are either negative or below PAT growth rates. For me, this is a company that is not falling in the investor-friendly range. Though there can be other factors that can fall in its favor. Only a deeper analysis will confirm it.
If PAT is growing but EPS is not growing, it is a case of too much share liquidation. I personally consider this occurrence as a negative indicator, highlighting non-investor-friendly management. Why? Because shares issuance is in the control of the top management. If shares are issued so rampantly that it is causing negative EPS growth, it is not serving the shareholder’s value.
Valuation metrics are crucial in GARP investing as they help determine if a company’s stock is reasonably priced. Commonly used valuation metrics include the price-to-earnings (P/E) ratio, price/earnings-to-growth (PEG) ratio, and price/sales ratio.
These metrics provide insights into a company’s valuation relative to its earnings or sales figures.
P/E Ratio: The P/E ratio is a valuation metric used to assess the relative price of a company’s stock compared to its earnings. It is calculated by dividing the current market price per share by the earnings per share (EPS). A high P/E ratio suggests that investors are willing to pay more for each unit of earnings, indicating a potentially overvalued stock. The high PE of quality companies also indicates that the stock is in high demand.
PEG Ratio: The PEG ratio takes into account a company’s growth rate alongside its P/E ratio. It provides a measure of a stock’s valuation relative to its earnings growth. A PEG ratio below One (1) is generally considered favorable, indicating that the stock may be undervalued relative to its growth prospects.
P/S Ratio: The P/S ratio is a valuation metric that compares a company’s market capitalization to its total sales revenue. It is calculated by dividing the market price per share by the sales per share. The P/S ratio can help assess a company’s valuation compared to its sales performance. A lower P/S ratio may suggest a potentially undervalued stock, while a higher ratio may indicate an overvalued stock.
In GARP investing, finding a “reasonable price” is essential. Peter Lynch emphasized that a reasonable price should take into account a company’s growth prospects and industry norms.
A stock can be considered overvalued if its growth potential does not justify its current price, and conversely, undervalued if its growth potential exceeds market expectations.
An example of this kind is Infosys. The company experienced significant growth during the 2010s, driven by its strong positioning in the IT sector. However, there were instances when the stock became overvalued. It prompted GARP investors to exercise caution and assess whether the price reflected the company’s growth potential.
What we can do more is to analyze the PE number a bit deeper. How? By establishing the PE trend and estimating a forward PE (PE of the future).
For that, we will have to calculate the PE of the last 5 or 10 years. Note the price and EPS data for a 10-Yr time period (as shown below):
Mar ’12
Mar ’13
Mar ’14
Mar ’15
Mar ’16
Mar ’17
Mar ’18
Mar ’19
Mar ’20
Mar ’21
EPS
55.97
65.23
94.17
98.31
117.11
120.04
131.86
80.12
88.64
83.7
Price
589
788
1051
1257
1226
1216
1424
2001
1824
3165
P/E
10.52
12.08
11.16
12.79
10.47
10.13
10.80
24.98
20.58
37.81
Once these two data are available, calculate the PE ratio of the 10 years as tabulated above. Once the calculation is done, we can plot a line chart and establish a trend.
The ideal case will be to see a rising PE. Here we will use a forward PE greater than the current PE (PE-TTM)
In case of a falling trend, we will use a PE that is lower than the current PE (PE-TTM).
The above two steps have established the ‘future earning growth rate’ and ‘Forward PE’. Now, we are ready to confirm if the stock is showing the characteristics of “growth at a reasonable price (GARP)?” How to do it? By calculating the GARP multiple.
PEG Ratio (Let’s call it GARP Multiple)
The lower is the GARP multiple (PEG ratio) the better. If the PEG ratio is below one, the stock’s price is said to be at par with its growth rate. If the PEG ratio is below one, the stock can be said to be undervalued. There is a difference between low PE stocks and GARP stocks. The stocks showing a low GARP multiple may have a high PE ratio, but their PEG will be close to one or below.
Diversification is crucial when constructing a GARP portfolio. By selecting growth stocks from various sectors and industries, investors can mitigate risks associated with individual companies or sectors. GARP investors aim to identify stocks with a combination of solid growth potential and reasonable valuations.
An illustrative example of a GARP portfolio in the Indian context might include companies like HDFC Bank, Asian Paints, and Infosys, which exhibited strong growth potential while maintaining reasonable valuations during certain periods.
Implementing the GARP (Growth at a Reasonable Price) investing strategy involves a series of logical steps that can help investors effectively apply this approach to their portfolio. Here is a breakdown of the process:
Clearly articulate your investment objectives, taking into consideration factors such as risk tolerance, investment horizon, and financial goals. This will provide a foundation for selecting suitable stocks within the GARP framework.
Conduct thorough research to identify companies with strong growth potential in the Indian market. Look for businesses that demonstrate consistent earnings growth, increasing sales figures, and a solid market position. Consider factors such as industry trends, competitive advantage, and product differentiation. Our Stock Engine can be a tool that can help in stock research.
Assess valuation metrics such as the price-to-earnings (P/E) ratio, price/earnings to growth (PEG) ratio, and price/sales (P/S) ratio to determine if a stock is reasonably priced. Compare these metrics to historical data, industry averages, and peer companies to gain insights into a stock’s valuation relative to its growth potential.
Evaluate the quality of a company’s management team and their ability to execute growth strategies. Look for experienced and visionary leaders who have a track record of delivering results. Assess their strategic decisions, capital allocation, and ability to adapt to changing market dynamics.
Build a diversified portfolio of GARP stocks from different sectors and industries. Diversification helps mitigate risks associated with individual stocks or sectors. Allocate funds across companies with varying market capitalizations and growth prospects to balance potential returns and risks.
Continuously monitor the performance of your GARP portfolio. Stay updated with company-specific news, industry developments, and macroeconomic factors that may impact the growth potential and valuation of your holdings. Regularly review your portfolio’s performance against your investment objectives and make adjustments as needed.
GARP investing requires patience and discipline. Avoid making impulsive investment decisions based on short-term market fluctuations. Stick to your investment strategy and give your chosen stocks sufficient time to realize their growth potential. Maintain a long-term perspective and resist the temptation to make frequent changes to your portfolio.
However, it is crucial to conduct thorough research, before buying a potential GARP stock. Generally speaking, GARP stocks trade at a high P/E multiples. Buying at such high PE multiples can be justified only by the stock’s future growth potential. One shall do thorough research on the future growth potential of the stock while practicing GAPR investing.
GARP investing, when executed diligently, can be a valuable tool in an investor’s arsenal, offering the potential for long-term success.
Investors seeking a robust stock screening philosophy can turn to a comprehensive approach based on cash flow, growth, margin, and return. This strategy emphasizes the importanceof positive cash flow from operations, high sales growth, strong gross margin, and superior return on equity (ROE). By evaluating stocks against these parameters, investors can identify companies with solid financials, growth potential, and profitability, enabling them to make informed investment decisions.
The philosophy revolves around the crucial elements of cash flow, growth, margin, and return. By analyzing stocks through these lenses, investors can gain a deeper understanding of a company’s fundamentals.
Next, we’ll delve into the significance of growth, particularly sales growth. Fast-growing sales not only indicate increasing demand for a company’s products or services but also increasing market share.
Finally, our ultimate target is to identify and invest in high-ROE companies. These are companies that generate high returns for their shareholders. But the idea is to identify such companies which will continue to make high ROE in times to come. Hence, we must also analyze the cash flow, margins, and growth aspects of the companies.
Positive net cash flow from operations is a fundamental indicator of a company’s financial health. It represents the cash generated by a company’s core operations. It is cash generated from the sale of goods and services, minus the cash paid for operating expenses.
A positive net cash flow from operations showcases the company’s ability to generate cash internally. This cash flow is vital for its day-to-day operations. Moreover, such cash flows can also be used for investing in growth opportunities and meeting financial obligations.
A company with a strong cash flow can fund its operationswithout relying heavily on external financing. This financial strength provides stability, as the company is less vulnerable to liquidity issues during challenging economic periods.
So, as an investor, our search for fundamentally strong companies should start with the cash flow analysis. This is why, my stock screening philosophy gives it the first priority.
Growth in sales reflects the demand for the company’s products or services. It also shows the company’s focus on its marketing and sales strategies. A combination of good products & services, and effective marketing and sales strategy builds the company’s competitive position. Such companies are more capable of capturing market share.
They may have a competitive advantage that enables them to outperform their peers in terms of revenue expansion. High sales growth can be an encouraging sign for investors, as it suggests the potential for future earnings growth and capital appreciation.
Companies with sustained high sales growth have, on average, experienced higher stock price appreciation and shareholder returns. For instance, D-mart (Avenue Supermart), a retail firm, has achieved an impressive annual sales growth rate of 17% per annum over the past 5-years. This has resulted in a significant increase in the market price of its stocks at the rate of 23% per annum.
One key metric that holds immense importance in assessing a company’s profitability and operational efficiency is the gross margin. Gross margin is calculated by subtracting the cost of goods sold (COGS) from total revenue and then dividing the result by total revenue. It is expressed as a percentage. It represents the proportion of revenue that remains after accounting for the direct costs associated with producing goods or delivering services.
1. Operational Efficiency: A high gross margin suggests that the company is adept at controlling its production costs, optimizing its supply chain, and managing its input expenses effectively. By maintaining a high gross margin, companies can allocate more resources toward research and development, marketing, or expanding their business. It thereby can bolster their long-term growth prospects.
2. Pricing Power: High gross margin often goes hand in hand with a company’s pricing power. Companies that possess unique or differentiated products, strong brand recognition, or a competitive edge in the market. This way they can command higher prices for their offerings. This pricing power allows them to generate more revenue per unit sold, leading to higher margins.
3. Resilience During Economic Downturns: During economic downturns or periods of increased competition, high-margin companies show more resilience. The ability to maintain a healthy margin even in challenging times demonstrates the company’s ability to remain afloat and profitable at all times.
Companies with high gross margins have a competitive advantage and are better positioned to weather industry downturns. A case in point is Grasim Industries, a cement manufacturer. It consistently maintains a gross margin of 65%, above the industry average. This strong gross margin is a result of their premium pricing strategy and operational efficiency. It leads to robust profitability and shareholder value creation.
From the perspective of investors, both Return on Equity (ROE) and Return on Capital Employed (ROCE) are important return ratios. They provide insights into a company’s profitability and efficiency. I personally prefer the use of ROCE. But ROCE is not so easy to calculate and comprehend. Hence, people may also use ROE to do the return analysis.
As an investor, our first preference should be to invest in high ROE and ROCE companies. But some industries have inherently low ROE and ROCE. Does it make these companies bad? No. But if high ROE and ROCE companies are available at better valuation levels, I’ll pick these companies first.
Studies have demonstrated that companies with consistently high ROE and ROCE tend to deliver superior long-term investment returns. An example is Nestle India. The company maintains consistently achieved an ROE of 85% and an ROCE of 50% or higher over the past five years. This remarkable performance is a testament to their efficient capital allocation.
By screening stocks based on the above four metrics, investors can identify companies with strong financials, growth potential, and profitability.
Users can use the Stock Engine’s Big Screener to apply some of the filters discussed above. For example, the big screener can screen stocks on the basis of the following metrics:
Soon, we’ll launch a pre-build screener theme that will exactly filter stocks based on the above four metrics. We’ll name that theme the “4 BIG FILTER.”
In a world marked by financial uncertainties and economic complexities, the pursuit of financial independence has emerged as abeacon of hope. It offers the promise of alife unburdened by monetary constraints. Financial independence is a concept gaining remarkable traction in recent times. It holds the potential to transform lives and empower individuals to breakfree from the rat race.
Imagine a life where you no longer depend on each paycheck to meet your basic needs. Your financial decisions are guided by personal aspirations rather than the constraints of your bank balance. Financial independence paves the way for such a liberating existence, where financial worries take a backseat, and yourfreedom of choice takes the central stage.
But what exactly is financial independence? This is exactly what we’ll discuss in this article. While discussing its benefits you’ll know about its enormity. You’ll know why nearly everyone should make the achievement of financial freedom their primary goal.
The significance of financial independence extends far beyond mere financial stability. It transcends the conventional definition of success. It shifts the focus from the rat race of acquiring possessions to the pursuit of meaningful experiences. By gaining control over your finances, you gain control over your life. This is state of a life where your money works for you, not the other way around.
Financial independence is a state where one’s assets generate enough passive income to pay for the required expenses of life. In this state of independence, people need not work (do a job) to earn money. Let me show you an infographic that depicts the state of financial independence.
The state of financial independence can be broken down into five (5) logical steps. It all starts with having an ample size asset base. The accumulated assets will yield returns in the form of passive income. For a financially independent person, this passive income source is large enough to take care of the spending and re-investment needs. Let me explain to you each step briefly:
The Asset Base: In this step, the money is invested and asset accumulation is done over time. The trick is to buy quality assets at an undervalued price. The assets can be stocks, mutual funds, real estate property, bank deposits, annuities, etc.
Return on Asset: The accumulated assets should be capable of yielding regular returns. The returns can be in the form of cash (like dividends, interest, rent, etc) or capital appreciation.
Passive Income: To achieve financial freedom, passive income is the keyword. It is a source of income that continues to yield on its own without our intervention. But to start a stream of passive income, the right assets must be accumulated. If the passive income is big enough, a person can achieve financial freedom.
Required Expense: Let’s take the example of two brothers, one lives in a large city, and the other in a small town. In a large city, the cost of living a comfortable life is say Rs.1,35,000 per month. In a small the cost of living is Rs.50,000. So, to achieve financial freedom, the minimum passive income the two brothers will need is Rs.135000 and 50000 respectively.
Re-Investment: The cost of living increases with time (inflation). Hence, to maintain the state of financial independence, one must re-invest and keep increasing the size of the asset base.
To reach the state of financial freedom, one must never forget the critical step of asset building. Without assets, there will be no passive income hence no freedom from the rat race.
Now that we know about what is financial independence, let’s start to discuss the process of achieving the goal.
There is a process to achieve financial independence. It is a tough goal to achieve, hence following a process will make it comparatively comprehensible. We can divide the process into three stages. It starts with working on the preconditions. Once the preconditions are met, the actual implementation stage will begin. Finally, the goal of financial independence itself can be achieved in stages.
Preconditions: There are a few things that need to be done before attempting to attain financial independence. In this stage, one tries to improve one’s financial health. These improvements in turn help one to climb the peak of financial independence.
Implementation: This is where the core action of asset building & passive income generation is implemented. Here we will discuss how one needs to map the mind to successfully implement the idea of achieving the goal.
Stages of Financial Independence: All financially independent people (families) are not the same. Out of 10,000 people, only one (1) can reach the first stage. Even a lesser number of people (families) can read the second stage. The third stage is rare. Maybe, only one in 10,00,000 can ever reach there. Read more to know what are these stages and how to achieve them.
Let’s start discussing the whole process with stage one, preconditions.
If financial independence represents a house, then these preconditions are the foundation of the house.
The goal of financial independence is such that many aspire to achieve it. But it is no ordinary goal. To achieve this goal, it is necessary to follow a process. If financial independence is the superstructure, then the foundation of this superstructure is the preconditions that we will discuss now.
There are three preconditions that one must take care:
Emergency Fund Creation: The asset purchase should start only after a minimum-size emergency fund is created. The emergency fund consists of three components, cash, life cover, and health cover. The size of each component is linked to one’s monthly expense (E). The cash should be at least six times E. Health coverage should be at least 15 times E, and the life cover should be at least 120 times E.
Cushion Savings: The size of the cushion savings should be at least six times one’s monthly expenses (E). The cash component of the emergency fund will come in handy when emergency strikes. Cushion savings will be used to manage daily expenses. Save your monthly income, instead use cushion savings to manage regular expenses. Use monthly income to replenish the depleted cushion savings. In your mind, the way to manage expenses should look like this.
#4. Implementation of Financial Independence
The above flow chart is a representation showing how one can visualize the implementation of financial independence. Earning money is the first step and then living a frugal life will lead to more savings. Investing the saved money to buy assets can ultimately lead to financial freedom.
Financial freedom is only one goal. In real life, one needs to manage other goals as well. So, one must simultaneously invest to manage other financial goals as well. With this simple mind-mapping, let’s proceed and see the actual implementation process of this step.
In our endeavor toward financial independence, we must learn two things, how to make our income grow continually and frugality. What is Frugal living? Maintaining a lifestyle that is lower than what one can actually afford. Our frugal habits give us the ability to save a majority portion of our income. Combine frugal living with income growth, and it becomes an endless source of savings.
Let’s understand it using an example. Suppose there is a person who earns Rs.100,000 per month. He lives frugally (saving 50% of his income). His income increases by 10% per annum. Let’s see his savings pattern for the next 5 years.
In 5 years the savings of the person rose from Rs.50,000 to Rs.73,205 per month. The person was anyways saving heavily (50%). But as the quantum of savings is increasing every year, its impact on one’s ability to invest is phenomenal.
This is a critical milestone in the journey toward financial freedom. It must be implemented intelligently as equity investing involves a high risk of loss. But if invested properly, equity can yield high returns. In the long term, properly invested money in equity can grow at a rate of 18-20% per annum. One can accumulate equity either by buying stocks directly or through the mutual fund route.
One must continue to buy and hold equity for at least 30-35 years. When quality equity is given such longer holding times, the capital actually begins to compound. For example, investing two lakhs in equity for the next 35 years at 22% per annum will grow to become Rs.20 Crore.
It is advisable to keep two separate asset bases, one for financial independence and the second to manage other financial goals.
In asset base #2, one can keep it well diversified. On one side it can be heavy on quality buy undervalued mid and small-cap stocks. On the other hand, it must also contain non-equity assets like debt funds, bank deposits, gold, REITs, etc.
Breaking down financial independence in stages can help achieve it easily. Financial freedom is a goal that is like a full marathon. One cannot sprint and reach the finish line. It can be achieved only slowly, in stages. There can be three stages of financial independence:
Stage 1 (Basic Independence): In this stage, the passive income generated from assets can fund all basic necessities of life. The basic necessities can be food, clothing, accommodation, utility bills, fees, basic subscriptions, etc. After paying for all these necessary expenses, only little is left to spend on the comforts and even less on the luxuries. For example, in this stage one’s passive income = 1.5x times the basic expense needs.
Stage 2 (Comfort Independence): In this stage, the passive income becomes large enough to take care of all comfort needs. Comfort needs can be like a bigger house, car, etc. It can also be full-time house help, air-conditioned rooms, gymming expense, dining out, entertainment, etc. For example, in this stage one’s passive income => 3x times the basic expense needs.
Stage 3 (Luxury Independence): In this stage, the passive income becomes large enough to take care of the temptations to spend on luxuries. Luxury spending can be big vacations, a posh house, fast cars, binge purchases, etc. For example, in this stage one’s passive income => 10x times the basic expense needs.
So the right strategy will be to put money proportionally in each goal separately. The idea is to keep the goal of financial independence isolated from other goals.
Financial independence can be achieved when “required” income will continue to drip-in even when we are sleeping. We should not be required to work to generate income to manage our expense needs.
Income generated from a job or business is not passive income. It is active income. The idea is to work and generate active income. Then divert at least 50% of the active income to accumulate assets (equity).
But equity accumulation is not enough. It is more important to convert equity into a pure passive income-generating asset. Which are such assets? A few best examples of such assets are the following:
Asset
Passive Income Form
Deposits
Interest
Stocks
Dividend
Real Estate
Rent
Annuity
Pension
Quick Tip:
A sure way of becoming financially independent starts with living a frugal life. Frugality does not mean leading a life of misery. It means, diverting a bigger proportion of one’s income towards the net worth building.
A person who lives a frugal life ensures that a big chunk of his/her income is available as savings. This is a huge advantage. Why? Because this available liquid cash can be used to invest in equity. As equity earns higher returns, over the long term such investments can build a sizeable corpus.
The first part of this corpus shall be used to manage the “other financial goals” of life.
The second part shall be used for “retirement” (financial independence}.
The Credit Utilization Ratio is a crucial aspect of credit scoring. It measures the percentage of available credit a person is using. It is calculated by dividing total credit card balances by the sum of credit limits. For instance, if someone has a credit limit of INR 100,000 and an outstanding balance of INR 30,000, their utilization ratio is 30%.
Understanding Credit Utilization Ratio is crucial for maintaining a healthy credit profile. A good credit profile gives access to better credit opportunities in the future. By keeping credit card balances low and using credit responsibly, individuals can improve their creditworthiness.
In the realm of personal finance, Credit Utilization Ratio is a crucial metric. It reflects the percentage of available credit one utilizes. Understanding and managing credit utilization can significantly impact credit scores. This score can influence lenders’ perceptions of our financial responsibility. By maintaining a low utilization ratio, we showcase prudent credit management, leading to improved creditworthiness. It eventually leads to better credit terms.
The Credit Utilization Ratio is a key metric used in credit scoring that represents the percentage of available credit a person is currently using.
It is calculated by dividing the total outstanding balances on credit accounts by the sum of all credit limits. This ratio offers insights into an individual’s credit management habits and is crucial for evaluating creditworthiness.
The formula for Credit Utilization Ratio: Credit Utilization Ratio = (Total Outstanding Balances) / (Total Credit Limits) * 100 = (30,000) / (100,000) * 100 = 30%
Explanation: In this example, Raj’s Credit Utilization Ratio is 30%. It means he is using 30% of his available credit limit (Rs.100,000). This ratio is calculated by dividing his outstanding balance (Rs.30,000) by the credit limit (Rs.100,000) and then expressed as a percentage.
A Credit Utilization Ratio of 30% or below is generally considered good. It will positively impact Raj’s credit score. It indicates that he is using credit responsibly and not maxing out his credit card. Keeping the Credit Utilization Ratio low is a prudent financial practice.
Credit utilization is a crucial factor in credit scoring because it reflects how responsibly someone manages their credit. It’s simply the percentage of credit they’re using compared to the total credit they have available. A high credit utilization ratio, meaning they’re using a large portion of their credit, can negatively impact their credit score. This is because it suggests they may be relying too much on credit. The logic is that if a person’s income-to-expense ratio is low, he will have to dig into his credit to manage expenses.
On the other hand, a low credit utilization ratio, where they’re using only a small part of their credit, can positively affect their credit score. This indicates that the person has a high income-to-expense ratio. Lenders like to see low utilization because it shows they’re not taking on too much debt and are less likely to be a risky borrower.
Statistics vividly highlight the importance of maintaining a healthy credit utilization ratio.
For instance, individuals with a low utilization ratio (below 30%) tend to have higher credit scores. It makes them more likely to qualify for favorable interest rates on loans and credit cards.
On the other hand, those with high utilization ratios may face difficulties obtaining credit or end up paying higher interest rates.
Statistics reveal a strong correlation between responsible credit utilization and improved financial well-being. This underscores the need to manage credit wisely to secure a brighter and more stable financial future.
Suppose there is a person who carries two credit cards. We’ll see how the credit utilization ratio is calculated in this case. Let me give you the actual case in consideration.
The First Card has a credit history of 10 years. Its credit limit is Rs.10 Lakhs. Generally, the person maintains a credit limit of 15% on this card.
The Second Card has a credit history of only a month. Its credit limit is Rs.1.4 Lakhs. Generally, the person maintains a credit limit of 70% on this card.
We’ll use this example to learn to calculate the credit utilization ratio of a person carrying multiple credit cards. Moreover, we’ll also use this example to bring forth the case of wise credit management.
But first, let’s learn to calculate the utilization ratio of multiple cards.
To calculate the credit utilization ratio for a person carrying multiple credit cards, we’ll consider the combined credit limits and outstanding balances across both cards. Let’s calculate the credit utilization ratio for each card and then the overall ratio:
First Card: Credit Limit: Rs. 10,00,000. Credit Utilization: 15% (Generally maintained by the person). Credit Utilization on First Card = 15% of Rs. 10,00,000 = Rs. 1,50,000.
Second Card: Credit Limit: Rs. 1,40,000. Credit Utilization: 70% (Generally maintained by the person). Credit Utilization on Second Card = 70% of Rs. 1,40,000 = Rs. 98,000
Now, let’s calculate the overall credit utilization ratio:
In this example, the person’soverall credit utilization is approximately 21.75%. This means they are using around 21.75% of their total available credit across both cards.
So now we know how the credit utilization ratio is calculated for a person, with multiple credit cards, for the purpose of credit rating evaluation. We’ve seen that for one credit card, the utilization ratio is much within the acceptable limits. But at times the second credit card gets overutilized. But the overall credit utilization of the person is 21.75%.
In this case, while one credit card is getting overutilized (70%), the overall credit utilization of the person is still 21.75%. As the overall credit utilization ratio is relatively low and well within acceptable limits (typically below 30%), the negative impact on the person’s credit rating may be minimal.
Maintaining a low overall credit utilization is generally viewed favorably by credit scoring models and lenders. Even if one credit card has a higher utilization ratio, the fact that the overall utilization is still low suggests that the person is managing their credit responsibly.
It’s important to note that credit scoring models consider various factors when evaluating creditworthiness, and credit utilization is just one component. While a high utilization ratio on one card may have some influence on the credit score, the overall impact might not be significant if the person maintains alow overall utilization ratio. Though, other factors such as on-time payments and positive past credit history also have a major influence on one’s credit rating.
While having a credit utilization of 0% may seem like a responsible approach, it may not necessarily be ideal for your credit score. Having some credit utilization, typically around 1% to 10%, is generally considered more favorable. A credit utilization of 0% indicates that you are not utilizing any of your available credit. As a result, it may not give creditors enough information to assess your creditworthiness.
Creditors want to see evidence that you can manage credit responsibly. Utilizing credit and making timely payments show that you can handle debts effectively. A small credit utilization demonstrates that you are using credit but not becoming overly reliant on it, making you a more attractive borrower.
Allow me to address common misconceptions and myths related to credit utilization and credit scoring. Knowing these can help one make informed decisions about their credit management. Let’s clarify some misunderstandings to shed light on these crucial concepts:
Misconception 1: Closing unused credit cards improves credit score.Clarification: Closing unused credit cards may actually harm credit scores. It reduces your total available credit, potentially increasing your credit utilization. Hence, one can keep old credit cards open, especially those with no annual fees. It will contribute to a longer credit history and eventually improves credit score.
Misconception 2: Only high-income individuals have excellent credit scores.Clarification: Credit scores are based on credit history, not income. While a higher income can aid in managing debts, anyone with responsible credit habits can achieve an excellent credit score. Consistently paying bills on time and maintaining low credit card balances are key factors in building good credit, regardless of income.
Misconception 3: Checking your credit score hurts your credit.Clarification: When you check your own credit score (a soft inquiry), it does not impact your credit. However, applying for new credit (a hard inquiry) may cause a temporary dip in your score. Regularly monitoring your credit is essential for detecting errors and staying informed about your credit health.
Credit card holders with multiple credit cards can take proactive steps to keep theiroverall credit utilization low. Thereby, it will enhance their credit ratings and overall financial health. The Credit Utilization Ratio plays a vital role in credit scoring, and maintaining a low ratio demonstrates responsible credit management to potential lenders.
To achieve this goal, people can do the following
Monitor Credit Card Balances: Regularly monitor credit card balances and strive to keep them as low as possible. Avoid maxing out credit cards, even if it means spreading expenses across multiple cards.
Pay Balances in Full and On Time: Always pay credit card bills in full and on time to avoid accruing unnecessary interest and late fees. Timely payments contribute significantly to a positive credit history and improved creditworthiness.
Avoid Opening Multiple Cards Simultaneously: Opening several credit cards in a short period may lead to hard inquiries and reduced average account age. Instead, consider obtaining new credit as needed.
Utilize Old Credit Cards Responsibly: Rather than closing old, unused credit cards, consider using them occasionally for small purchases and promptly paying off the balance. This approach helps maintain a longer credit history and positively impacts credit scores.
Fundamental analysis is a cornerstone of successful stock investing. It empowers individuals to make well-informed decisions in the dynamic world of the stock market. This approach goes beyond the analysis of short-term market fluctuations. Instead, it focuses on evaluating the intrinsic value of a company, uncovering its true worth.
By conducting fundamental analysis independently, investors can develop a deeper understanding of the companies they invest in. Consequently, they can make more confident decisions based on their own research and analysis. It is a skill that cannot be learned in a short period, the understanding grows over time upon practice.
Fundamental analysis is a broad study of business. Here not only the impact of underlying business on its stock price is studied, but the outside influence (like of economy) is also considered.
Fundamental analysis is suitable for long-term investors.
It is also important to note that the stock market is full of low-quality stocks. On one hand, we have fundamentally strong stocks, and on the other hand, we have a plethora of weak stocks. Fundamental analysis is a strategy to differentiate between fundamentally weak and strong stocks.
Intrinsic value is the price at which an investor should buy a stock. Intrinsic value is also called true value or fair price. Buying stocks above intrinsic value means buying an overvalued stock.
Its purpose is to provide transparency and accountability to shareholders and other interested parties by disclosing relevant information about the company’s operations, financial position, and future prospects.
Here are a few sections of the annual report that a fundamental analyst should read in particular. We’ll specially discuss in more detail reading and analyzing the financial statements (SL.No: 5) later in this article.
Financial Highlights: This section offers a snapshot of the company’s financial performance for the year, typically including key figures such as revenue, net income, earnings per share, and dividends.
Management Statement: This is usually a letter from the company’s CEO or Chairman, summarizing the company’s achievements, challenges, and future outlook.
Management Discussion & Analysis (MD&A): This section provides a detailed analysis of the company’s performance, discussing the factors influencing its results, industry trends, and future strategies. It helps investors understand the management’s perspective on the company’s performance.
Auditor’s Report: This report is prepared by the company’s external auditor and includes their opinion on the accuracy and fairness of the financial statements.
Financial Statements: These statements include the balance sheet, income statement, cash flow statement, and statement of changes in equity. They provide a comprehensive view of the company’s financial position.
Notes to Financial Statements: These notes provide additional information and explanations for specific items in the financial statements.
Sustainability/CSR Report: Some companies include a section on their sustainability efforts and corporate social responsibility initiatives.
Opportunities and Risks: This section identifies and explains potential risks and opportunities that may impact the company’s performance.
However, when the truth comes to light, and the actual revenue figures are revealed, the stock price may plummet. Such a situation can cause significant losses for investors who relied on the falsified information.
Financial ratios are essential tools in fundamental analysis, providing valuable insights into a company’s financial health and performance. These ratios offer a standardized way to measure various aspects of a company’s operations, making it easier to compare performance across different companies and industries. Here are eight of the most important financial ratios that should be included in the fundamental analysis:
Formula: P/E Ratio = Market Price per Share / Earnings per Share (EPS)
Significance: The P/E ratio indicates how much investors are willing to pay for each dollar of a company’s earnings. A higher P/E ratio suggests that investors have higher growth expectations for the company.
Interpretation: A high P/E ratio may imply that the stock is overvalued or that investors anticipate strong future earnings growth. Conversely, a low P/E ratio might indicate an undervalued stock or expectations of lower earnings growth.
Caution: The P/E ratio should be used cautiously, as it may not accurately reflect a company’s true value. It may vary widely between industries, and high P/E ratios can also be a result of inflated stock prices.
Formula: P/B Ratio = Market Price per Share / Book Value per Share
Significance: The P/B ratio compares a company’s market value to its book value (net assets). A P/B ratio below 1 may indicate an undervalued stock.
Interpretation: A P/B ratio below 1 suggests that the stock is potentially undervalued, as the market price is lower than the company’s net assets. However, this could also indicate underlying issues with the company or market sentiment.
Caution: The P/B ratio should be used in conjunction with other valuation metrics, as it may not account for intangible assets and may not be suitable for companies with significant intellectual property or brand value.
Formula: PEG Ratio = P/E Ratio / Annual Earnings Growth Rate
Significance: The PEG ratio combines the P/E ratio with the company’s earnings growth rate, providing a more comprehensive assessment of a stock’s valuation. A PEG ratio below 1 may indicate that the stock is undervalued relative to its earnings growth potential.
Interpretation: A PEG ratio below 1 suggests that the stock’s price is relatively low compared to its earnings growth, potentially indicating an attractive investment opportunity. Conversely, a PEG ratio above 1 might suggest an overvalued stock in relation to its earnings growth.
Caution: While the PEG ratio can be a useful tool, it is not without limitations. It relies on projected earnings growth, which may be subject to change, and it may not fully capture other factors influencing a stock’s value.
Formula: Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity
Significance: The debt-to-equity ratio measures a company’s financial leverage and risk. A high ratio suggests that the company relies heavily on debt financing.
Interpretation: A high debt-to-equity ratio may indicate a higher financial risk, as the company has more debt relative to its equity. A lower ratio is generally considered more favorable, as it suggests a more conservative financial structure.
Caution: The ideal debt-to-equity ratio varies by industry, and high debt levels could make a company more vulnerable to economic downturns or rising interest rates.
Formula: Current Ratio = Current Assets / Current Liabilities
Significance: The current ratio assesses a company’s ability to meet short-term obligations. A ratio above 1 indicates sufficient liquidity.
Interpretation: A current ratio above 1 suggests that the company has enough current assets to cover its short-term liabilities. Higher current ratios are generally considered more favorable.
Caution: An extremely high current ratio may imply that the company is holding excessive levels of non-productive assets, while a very low current ratio may indicate potential liquidity issues.
Formula: Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Significance: The quick ratio is a more stringent measure of liquidity, excluding inventory. It reflects a company’s ability to pay short-term liabilities without selling inventory.
Interpretation: A quick ratio above 1 indicates that the company can cover its short-term liabilities without relying on inventory sales. Higher quick ratios are generally preferred.
Caution: Similar to the current ratio, an extremely high quick ratio might imply excessive non-productive assets, while a very low ratio may signal potential liquidity challenges.
Formula: ROE = (Net Income / Shareholders’ Equity) x 100
Significance: ROE measures a company’s profitability in relation to shareholders’ equity. A higher ROE indicates better returns for shareholders.
Interpretation: A high ROE suggests that the company is effectively utilizing shareholders’ funds to generate profits. A consistently high ROE is often seen as a positive sign of management efficiency.
Caution: ROE should be analyzed in the context of industry peers and the company’s growth stage. High financial leverage can artificially inflate ROE, while low or negative ROE might indicate underlying problems.
Formula: ROCE = (Operating Profit / Capital Employed) x 100
Significance: ROCE measures a company’s ability to generate profits from the total capital invested in its operations, including both equity and debt.
Interpretation: A higher ROCE indicates that the company is efficiently utilizing its capital to generate profits. It provides insights into how well the company is using its assets to generate returns for both equity shareholders and debt providers.
Caution: ROCE should be considered alongside other financial ratios. A high ROCE may indicate strong financial health, but it could also be a result of high financial leverage, which carries a higher risk. Additionally, variations in accounting practices can impact the calculation of ROCE across different companies.
Significance: ROA gauges a company’s efficiency in using its assets to generate profits.
Interpretation: A higher ROA indicates that the company is more efficient in utilizing its assets to generate profits. Comparing ROA with industry averages can provide context for performance evaluation.
Caution: ROA can vary significantly between industries, and capital-intensive businesses might have lower ROA compared to knowledge-based industries.
Significance: Gross margin measures the percentage of revenue that exceeds the cost of goods sold. A higher gross margin indicates better profitability.
Interpretation: A higher gross margin suggests that the company is generating a greater profit from its core business activities. It also allows for a comparison of a company’s profitability to others in the same industry.
Caution: Gross margin can be influenced by industry dynamics, competition, and changes in input costs. It should be interpreted alongside other profitability and efficiency ratios.
By analyzing these financial ratios, investors can gain insights into a company’s profitability, liquidity, debt levels, and overall financial stability.
Analyzing a company’s financial statements is a critical component of fundamental analysis. Financial statements, comprising the income statement, balance sheet, and cash flow statement, provide a comprehensive overview of a company’s financial performance, position, and cash flow activities. Here’s how to effectively analyze each financial statement:
The profit & loss(P&L)account is the most dynamic financial report of a company. First of all, it talks about how much income the company has generated in thelast year (12 months). In India, the financial year of a business generally starts on the first of April and ends on the 31st of March. So when the P&L account is prepared it is prepared for a period between the 1st of April and the 31st of March.
The P&L accounts also indicate the various expenses that the company has incurred in the last year (FY).
Once the income and expense line items are listed by the company, the next important deduction that is made is called the gross profit. By adjusting depreciation, interest expense, and tax expense, thenet profit (PAT) of the company is deduced in the P&L account.
In the profit and loss account of Tata Steel, the “Total Income” component of the company is represented as (a) Revenue from operations, and (b) Other income. In FY ending 31-Mar’20, the company’s total income was Rs.60,840.09 Crore, out of which Rs.60,435.97 Crore is from operations and Rs.404.12 Crore is from other sources.
Note No 27 provides a break-up of ‘Revenue from operations’. Here we will get to know what the company means by operation income. For Tata Steel, it is the sale of products, sale of power and water, etc.
Note No 28 provides a break-up of “Other Income” sources. For Tata Steel other income is dividends, interest, change in value of investments (mutual funds), sale proceeds of capital assets, etc.
Now we will look at the company’s expense statements. First, we will look at the absolute numbers and then at their respective notes. The company generally classifies its various expenses into a few expense heads. So the first thing we can look at here is, what are the expense heads of the company.
Generally speaking, depending on the type of business, similar companies will have similar expense heads. Like expense heads of manufacturing companies will be alike.
The first expense head of Tata Steel is ‘Cost of material consumed’. This expense head has consumed Rs.17,407 crore for Tata Steel in FY ending 31-Mar’20. Unfortunately, I did not find any associated notes against this expense head. As an analyst, I would’ve loved to know more about which are ‘materials consumed’”’ and in which proportion.
The second expense head is ‘Purchase of stock-in-trade’. This line item consumed Rs.1,563 crore in FY 2019-20. But again the company has not provided any break-up of these items.
Though the purchase of stock-in-trade means all those items with company purchases as finished goods. These are purchased and sold by the company without further processing. Remember these items are not raw materials for the company. They can either be finished goods brought forward in the current year from last year’s inventory, or trade items.
The third expense head is “Changes in inventories of finished and semi-finished goods, stock-in-trade and work-in-progress”. This expense head is calculated by noting how much inventory, WIP, and stock-in-trade were there at the beginning of the year and the end of the year. For Tata Steel, in FY2019-20 this value was in negative (Rs.564 Crore). To understand more about this expense head, let’s look at note no 29.
There are three types of inventories for the company: (a) Work in progress: those raw material or items which are taken from stores but has not reached the finished goods storage bay. They are still in operation. (b) Finished Good is ready for sale products. (c) Stock in trade.
The fourth expense head is “Employee benefit expenses”.
This becomes more clear when we will see the note no 30. You can see that the salaries and wages cost Rs.4,231 Crore. The contribution to PF is about Rs.477 Crore, and the cost of the welfare scheme is Rs.328 Crore.
The fifth expense head is classified as “Finance Cost”. Under this head, the cost to Tata Steel was Rs.3,031 crore. This is the cost incurred by the company when it borrows funds.
The borrowed funds can be bank loans, debt from financial institutions, bonds, credit lines, etc. The interest paid to the lenders on the borrowed funds is classified as a finance cost. Note 31 provides more details on the finance cost.
The sixth expense head is “depreciation and amortization expenses”. For Tata Steel, this cost is amounting to Rs.3,920 Crore. This is just an accounting adjustment and may not represent the actual cash outflow. It is important for analysts to understand the concept of depreciation. Details of the cost booked under Depreciation and amortization can be found under note no 32.
What is depreciation? It is an accounting method to book the cost of an asset as an expense not in one go but over time.
Example: Suppose a company has a net profit of Rs.10 Crore. It buys a machine (asset) costing Rs.15 crore in the year 2020. The expected life of the machine is say 5 years. In this case, if the company books the total cost of the machine (Rs.15 crore) in the year 2020 itself, its net profit will go in negative (10 crore minus 15 crore).
Hence, instead of booking all costs in one year, the company is allowed to depreciate its asset over the next 5 years. It means, each year the company can book Rs.3 crore (Rs3 crore x 5 years = Rs.15 crore).
P. Note: Depreciation is for tangible assets. Amortization is for intangible assets.
The seventh and last expense head is “other expenses”. All expenses which do not fall under the above six heads are booked under this head. For Tata Steel, this expense line item had a cost of Rs.23,803 crore. It is the biggest expense head for Tata Steel.
Generally speaking, when I see such high costs booked under the “other expenses” head I do not feel comfortable. Though details of other expenses are provided by the company under note no 33.
When the company generates some income or expenses on account of such activities which are not typical, it can be listed as exceptional items. In the case of Tata Steel, in FY 2019-20, the cost booked under exceptional items is Rs.1,703 Crore. An explanation of all these costs has been provided in note no 34.
What we have seen till now is the list of all incomes forming the “Total Income” of the company. We have also seen a list of all expenses forming the “Total Expenses” of the company – including exceptional items.
Subtracting total expenses from total income as calculated above will give us “Profit Before Tax”. For Tata Steel, the Profit Before Tax number is Rs.6,610 Crore.
I’m not sure what was the reason behind opting for deferred tax, but this is again something that does not make me comfortable about the company.
As the company has gone for deferring its tax liability, its net profit after tax (PAT) is amounting to Rs.6,743 crore which is higher than PBT. [PAT = PBT – Tax Liability]
Profit and loss accounts give the status of profitability for a year. The cash flow report gives the status of cash flows for a year. But the balance sheet report tells the status of assets, liabilities, and equity from the day a company is formed.
The balance sheet tells how a company has handled its finances. Better utilization of finances ultimately leads to more profitability and cash flows. So we can say that for a company it all starts with its balance sheet. Let’s know more about it.
#4.2.1 Simplified Balance Sheet
The above image is a graphical representation of a balance sheet. What does a balance sheet balance? It is balancing Assets on one side and equity plus liabilities on the other. This gives us ourBalance Sheet Formula.
From a general perspective, this is what a balance sheet report tells us about the company.
Liability Side
Source of Fund: On the liability side, what we can find are the sources from where the company is arranging its finances. There are two ways a company can fund its business: (a) through the equity route and (b) through the debt route. A balance sheet report will tell what proportion is equity and how much is from debt.
Equity: In this type of funding, a company is selling the ownership (shares) of its business in the stock market. People are buying those shares and becoming shareholders. The money so accumulated from the sale of shares is the capital raised through the equity route.
Liability: There are two types of liabilities: Long term and short-term. When a company takes a loan for which the payback time is more than 12 months, it is a long-term liability. Likewise, loans with a payback time shorter than 12 months will be a short-term liability (also called current liability). The money so accumulated from debt is a liability for the company.
Utilization of funds: On the liability side, what we have seen are the two sources of funds; equity and debt (total capital). On the asset side, we will see how the company uses these funds to run its business. Running a business can be seen as a two-fold process: (a) running the operations, and b) growing the operations.
Non-current Assets: These majorly are constituted by fixed assets. A major portion of the total capital (equity & long-term debt) is used by the company to buy property, plant, and equipment. In other words, this money is used to build the infrastructure of the company.
How to read a balance sheet with ease? First, divide the whole report into five sections. What are these sections? Five sections are (1) equity, (2) non-current liability, (3) current liability, (4) non-current assets, and (5) current assets.
The first section of the balance sheet will be equity. Here the company declares how much equity (also called net worth) they have built-up as-of-date (from the date of inception).
Note 16 highlights more about Equity Share Capital. The company has an authorized share capital (maximum money it can raise from the share market) of Rs.100 crore. Out of this, the company has already raised Rs.96.42 crore (paid-up capital). How equity share capital is calculated? Share capital = Number of shares issued x face value (9.64 crore x Rs.10/share = Rs.96.42 crore).
Note 17 highlights more about Other Equity. It has two main components. First, there are general reserves of Rs.837.4 crore. Second, Retained earnings of Rs.1,030.76 crore. What are general reserves and retained earnings?
All profits recorded in the company’s P&L Account are first transferred to the balance sheet (Other Equity). One portion is kept as General Reserves and the other as Retained Earnings.
General reserves are kept aside to manage the future needs of the company. Retained earnings are the accumulated net profit of the company (to date) minus transfers to general reserves. It is from here (retained earnings) the shareholders are paid dividends.
Note 18 talks about the Financial Liability (Borrowings) of Rs.53.14 crore by the company. My first impression was that it is a bank loan whose tenure is more than 12 months from reporting. But they were actually deferred VAT payable in the future.
Note 19 talks about long-term provisions. Generally speaking, long-term provisions of the company are generally funds kept aside by the company for employee benefits. In our example company, provisions are made for gratuity, incentives cum welfare benefits, and contingencies.
What you can see in the above screenshot is a statement of the current liabilities of a company. In FY ending Dec’19, the company has posted a current liability of Rs.2,147 crore. The break-up of total current liability is also provided with details in Notes 46, 22, 23 & 24.
A majority portion of the current liability of the company is associated with the trade payables ofRs.1,494 crore (=34+1460). These are basically invoiced bills of the suppliers waiting to be paid.
In the next line of the balance sheet, what we have is Other current liabilities. Our example company has recorded Rs.133.96 crores against it. To know more about this line item, we will have to see note 24. Generally, companies post their statutory liabilities under this head. Any liability that cannot fit in the above-listed headings will go here.
Asset
What we will see now is how the company is utilizing its capital. How the capital is utilized? By accumulating non-current and current assets.
What are non-current assets? These are mainly the property, plant, and equipment of the company (also called fixed assets). Other types of non-current assets can be financial assets (like long-term investments). We can know more about them in the notes.
In Note 4 we can see the details aboutproperty, plant, and equipment. Check the above screenshot. It lists down items like land, building, plant, equipment, furniture, office items, and vehicles under this head. These are all fixed assets that are expected to add economic value to the company in the long term. Out of all the types of assets, this is the most capital-intensive of all (especially for manufacturing companies).
The next line item on the asset side of the balance sheet is capital work-in-progress (Rs.143.3 Crore). This is also related to property, plant, and equipment, but is recorded separately as the construction/execution work is still not complete. Once the execution work is finished, their numbers will be moved to the property, plant, and equipment line.
Under the head financial assets, one line item is investments (Rs.743.6 crore). One can see its details in note 5. In note-5, you can see that the company has invested its cash in two areas. First is tax-free bonds (Rs. 724.72 Crore), and second is shares (Rs. 18.88 Crore)
Another type of financial asset that the company has recorded in its balance sheet is loans (Rs.46.98 Crore). One can see its details in note 6. As you can see, a majority portion of the loan is under the head called Security Deposit (Rs.36.08 Crore). Generally, these are monies paid by the company against the property/apartments they have leased for office purposes, etc. The second common form of loans are monies issued to employees or group companies.
A good part of the capital raised by the company remains locked ascurrent assets. This is that portion of the money that cannot be used for property, plant, and equipment expansion, purchase of LT investments, etc. It is of paramount importance for the company to keep some of its assets as liquid as possible. These liquid assets are referred to as current assets.
In Note 8, our example company has provided the details of their inventories worth Rs.1,283.07 crore. Look into the list of items under the head inventory. It will give you the impression that these items are not strictly liquid. Let’s divide the whole list into 4-types: unfinished goods (illiquid), semi-finished goods (illiquid), finished goods (liquid if there is a demand), and spares (illiquid). It is the reason why some analysts remove inventory numbers to judge the company’s real liquidity levels.
In Note 9, we can see the details of our first financial asset (investments of Rs.1,007 crore). These are all such investments that are getting matured within the next 12 months. Typical types of current investments by companies are T-Bills, government bonds, fixed deposits, debt mutual funds, etc.
The next line item under financial assets is the trade receivables (Rs.124.33 crore). These are basically outstanding payments waiting to be received from the customers’ end. In notes, a good company also shows a break-up between receivables considered safe and unsafe.
Other items listed under the head ‘current assets’ can be short-term loans issued by the company to their employees or group companies. These are such non-cash items that can easily be en-cashed when due (by the way of adjustments etc).
Under the head ‘other current assets‘ our example company has recorded an amount of Rs.26.02 crore. They have provided the details of this item in note 15. These mainly include advances paid to suppliers, employees, etc. Our example company has also included “Balances with government authorities” here. Ideally, this should either be adjusted under ‘account payables” or shall come under “trade receivables”. But the company has put it here because maybe they do not expect this cash flow to happen any time sooner. It may be, a kind of NPA for the company.
Debt & Finance Cost: The debt (long-term and short-term borrowings) in the balance sheet increases the company’s finance cost which appears in companies’ profit and loss accounts.
Trade payables & Expenses: Trade payables of the balance sheet are a portion of theexpense to be incurred by the company in the next financial year (FY).
Tangible Assets & Depreciation: Tangible assets (property, plant, equipment, etc) valuation appears in the balance sheet. This value is net of accumulated depreciation. Depreciation applicable for a particular FY appears in the P&L account.
Investments & Other Income: Investments (non-current and current) made by the company are recorded in the company’s balance sheet. The income generated by these investments is recorded as other income in the P&L account.
Trade receivables & Income: Companies often sell their products and services to their customers on credit to earn income (income appears in the P&L account). This credit payment due, to be received by the next 12 months is recorded as trade receivable in the balance sheet.
Reading a balance sheet is only half the job done. It becomes even more interesting to make meaning out of the numbers printed here. How to do it? If we can understand the whole scheme of things (The Business) side of the balance sheet, its impact can be phenomenal. A very simplified representation of the balance sheet side of the business is shown below:
Look at the above infographics. It gives an idea of how the source of funds (Equity and liability) plays a role in funding non-current and current assets. You will also be able to understand which asset type is building long-term value for shareholders and which asset type is used only to ensure liquidity in the business.
Out of the balance sheet, profit & loss a/c, and cash flow report, perhaps the cash flow statement is the easiest report to read and comprehend. But in terms of effectiveness to judge the fundamentals of a company, this report is as valuable as the other two.
Cash is king for a company. If cash is flowing in and out at the required times, the company will remain afloat. The cash flow statement gives us this clarity about the company. Hence, a cash-rich company is always valued highly by analysts.
But a cash-rich company need not always confer with the idea of having ‘excess cash sitting in the bank’. A company can be said to be cash rich if its overall cash position remains positive.
How to judge a company’s cash position? By looking into areas from where the company is earning and spending its cash.
To judge a company’s cash position analysts resort to estimating free cash flow (FCF). Based on the estimated FCF, the intrinsic value of a company is estimated. The higher the FCF, the higher will be the company’s intrinsic value. When the intrinsic value of a company becomes positive and is also increasing, it is a clear sign of astrong cash position.
Example of a weak & strong cash position – How cash is king
Consider this hypothetically. There are two companies A and B.
Company A has reported Rs.1,000 crore profit in its profit and loss account. But it was unable to collect a single penny from its customers [all sale was on credit & no advance was received]. But the company had a total cash-out of Rs.850 crore. This company will have a negative cash flow. Net Cash Flow (-850) = Cash In (0) – Cash Out (850). Hence it has a weaker cash position.
Company B has reported Rs.10 crore profit in its profit and loss account. It was able to collect Rs.8.0 crore from its customer. The total cash-out in the same year was Rs.6.6 crore. This company has a positive cash flow. Net Cash Flow (1.4) = Cash In (8) – Cash Out (6.6). Hence it has a stronger cash position.
Why do companies do business? At the end of the day, the business is done to make money. How to quantify the money made by the company? One way of looking at it is through their “bank balance”. If the cash parked in the bank (cash, deposits, short-term investments) is growing year on year, it is a clear sign of the company making money.
How company can increase its bank balance? By generating excess cash from its business. Here the term “business” is classified into three activities: (a) operating activity, (b) investing activity, (c) financing activity. At the end of the year, there should be a net cash-in flow from the combined effect of these activities.
When there will be a net cash-in flow, the bank balance will go up. When there will be a net cash-out flow, the bank balance will go down.
This is what’s actually represented in a cash flow statement, that at the end of the year, the cash position of the company has increased or decreased. The cash flow report also shows the activities which brought cash and activities that consumed cash for the company.
To make more meaning of the cash flow report, it is better to read 3 or 5-year numbers in one go. Here is a snapshot of the five-year cash flow statement of Nestle India. You can see how its numbers behaved in the last 5 years.
What you see in the above screenshot is a summarised version of the cash flow statement. But the actual report is much more detailed. What are the details? There are detailed break-ups of all three activities: (a) Operating activity, (b) Investing activity, and (c) financing activity.
The statement of cash flow starts with counting how much cash the company’s operations have generated in the financial year. So the first line you will see will be “Cash Flow from Operating activities”.
Then the next line you will see is “Net Profit”. This value comes straight from the ‘profit and loss account’. In some statements, it is also referred to as “Net Profit before tax”. Please do not misunderstand it with Profit Before Tax (PBT).
So why in the Cash flow statement it is pronounced as …before tax? Probably it means “net profit before adjustment for the actual tax paid as of date“.
We have already discussed that onlyactual cash flows are recorded in this report. But PAT is not a true representation of the actual cash flow. So why use net profit (PAT) in the cash flow statement?
First things first, net profit is actually a result of cash flows happening in the company (actual or foreseen). How? Income is a cash flow. Expenses are cash flows. Interest & tax payments are cash flows. So the net of all these cash flows is “Net Profit (PAT).
But the problem with PAT is that some of these cash flows may not have actually happened. For example, all recorded income may not have been collected from customers. All expenses may not have still been paid.
So what is done in cash flow report is that, we take PAT in the first line, and then adjust it for the actual cash flows (in and out) which has happened in the financial year.
Please keep reading, this concept will become very clear in subsequent paragraphs.
From here onwards we will start reading the cash flow report of a company from top to bottom. From the first line itself, there are activities that will be adjusted with PAT. What are the adjustments?
Cash-in adjustments: All cash-in flows which has been accounted for in P&L a/c (as income), but have not actually happened will be subtracted from Net Profit (PAT).
Cash-out adjustments: All cash-out flows which has been accounted for in P&L a/c (as expense), but have not actually happened will be added to Net Profit (PAT).
D&A Expense: Rs.3,529 crore has been added back to PAT for Mar’20. This has been done because D&A expense is only an accounting adjustment. The actual cash-out may have happened a few years back. [Note: Rs.3,529 Cr, will appear in P&L a/c under the head “D&A Expense”]
Bad debts, advances, payments: Rs.144 crore has been added back to PAT. These debts, advances, etc which were actually paid in the past have become ‘bad’ in this FY. So no actual cash-out has happened in this FY.
Tax Expense: Rs.9,801 crore has been added back to PAT. This is done because it’s adjusted again at the end of operating activities as “Taxes paid (net of refunds = Rs.-5,846 crore. [Note: Rs.9,801 Cr, will appear in P&L a/c under the head “Total Tax Expense”]
Net Gain on Investments: Rs.-214 crore has been deducted from PAT on account of loss upon sale of the investment (example: shares of a company sold at a loss of -214 core).
Interest Income: Rs.-3,562 crore has been deducted from PAT. This is because the interest has accrued in FY’19-20 but the same is still not credited into the bank account. [Note: Rs.-3,562 Cr, will appear in P&L a/c under the head “other income”]
Dividend Income: Rs.-10 crore has been deducted from PAT. This is because it has accrued in FY’19-20 but the same is still not credited into the bank account. [Note: Rs.-10 Cr, will appear in P&L a/c under the head “other income”]
Finance Cost: Rs.924 has been added back to PAT. This is done because it’s adjusted again at the end of financing activities as “interest paid”. There is financing activity you will see a negative number (Rs.-924 crore).
As you can see, the next resultant number after adjusting for the above cash flows to Net Profit (PAT) isRs.42,882 crore (calculation shown below).
What does the number Rs.42,882 crore mean? It means, after adjusting for all actual cash-ins and cash-outs, the cash position of the company has actually improved compared to PAT (Rs.32,447).
But this position might soon change when we will take working capital into consideration. Why? Because this is where the bulk cash handling takes place.
Like above, now we will see how changes in working capital items will affect the net profit (PAT) recorded in the P&L account. Please note that all values shown here are represented as “Net Change in…” (This year Vs last year).
Again, if the item has caused a net cash-in flow for the company, it is recorded as positive. If the item has caused a net cash-out flow for the company, it is recorded as negative.
[Please note that all items indicated under the head “working capital” are either current assets or current liabilities (as recorded in company’s balance sheet). But the value indicated here are change in each items compared to last year. Any changes in these items will either cause a cash-in flow or cash-out flow for the company.
Negative numbers (Cash outflows)
Trade receivables change: Rs.-3,295 core is added to PAT. Negative value means, compared to last FY end, the company’s trade receivables have increased. When it will increase? When the company sells more than it collects (payments) from its customers. Hence it is considered as a negative number.
Un-billed receivables change: Same explanation as above.
Loan receivables change: Rs.-2 crore is added to PAT. This is because compared to last FY, the quantum of this item has increased in this FY (by Rs.2 crore). It means, more loans are pre-paid (like inter-company or advance to employees etc).
Change in Other assets: The quantum of ‘other assets’ has increased in the current FY by Rs.3,492 crore compared to last FY. This is the reason why, it is recorded as a negative number. In simple words, this line item has consumed cash worth Rs.3,492 extra this year.
Positive Numbers (Cash in-flows)
Inventories Change: Rs.5 core is added back to PAT. This means that compared to last FY end, the company has reduced its inventory by Rs.5 core. How inventory can be reduced? By sale of the item. Hence it is considered a cash-in.
Trade Payables: Rs.446 core is added back to PAT. It means, compared to last FY end, the company has increased the a/c payables by Rs.446 core. How do a/c payables increase? When more vendors’ invoices are waiting to be paid. More cash stays in the bank and is paid later.
Other financial liability: Rs.1208 crore is added back to PAT. When the quantum of financial liability increases (like a bank loan), its net result is an increase in cash for the company.
Inference #2
So this is all about cash flow from the company’s operations. If one wants to know how much ‘actual net cash’ is generated by the company’s operations, we need to add all the numbers back to PAT (see the screenshot of the calculation shown below).
Rs.32,369 is the real cash generated by operations. Now it is on the company how they want to use this cash. They can consume it for ‘investing activities’. They can also consume it for ‘financing activities’.
There are companies who may come short in ‘cash generated from operations’. Such companies has the option to generate cash from investing activities (like sale of investments etc) and form financing activities (like issue of new shares, bonds etc).
Net Cash Flow From Investing Activity
Few cash-consuming investing activities
Bank deposits placed: Rs.7,663 crore worth of new bank deposits have been bought by the company. This also yields ‘interest income’. This is a cash-consuming activity hence shown in negative. Hence it has caused a negative value in cash flow. Out of all cash generated by operations, Rs.7663 crore was used for FD.
Inter-corporate deposit placed: This is also like FD, but instead of a bank, a company deposit (CD) has been bought. Rs.14,905 worth of new CDs have been purchased. This also yields ‘interest income’. CDs cause a cash out hence a negative value in cash flow. Out of all cash generated by operations, Rs.14905 crore was used by CDs.
Purchase of investments: Rs.80,002 worth of new investment was cash purchased by the company. Hence it has caused a negative cash flow.
Purchase of Property Plan & Equipment (CAPEX): This is what is classified as the Capital Expenditure (CAPEX) of the company. While doing a price valuation of a company using DCF, a Capex number is used. The company has spent cash worth Rs.2,538 in Capex for FY ending Mar’20.
Few cash-generating investing activities
Proceeds from Bank Deposits: Rs.11,965 crore worth of bank deposits was redeemed by the company. This has increased the bank balance of the company by the same value, hence written as a positive number.
Proceeds from inter-corporate Deposits: Rs.14,432 crore worth of inter-corporate deposits was encashed by the company. This has increased the bank balance of the company by the same value, hence a positive number.
Redemption of investments: Rs.84,089 worth of investments have been sold by the company. This has increased the bank balance of the company by the same value, hence a positive number.
Disposal of Capital Assets: Rs.162 crore worth of capital assets has been sold by the company for cash. Hence it caused the cash balance of the company to increase by the same value. Hence a positive number.
Interest & Dividend received: Rs.3,729 crore and Rs.8 crore cash have been earned by the company on account of interest and dividend respectively. Hence it’s a positive number. [Note: Rs.3,729 Cr, & Rs/8 crore will appear in P&L a/c under the head “Other income”]
Inference
So to check how much net cash generation has been done the by the investing activities of the company, all values are added (see the screenshot shown below).
Generally, a growing company invests a huge amount of money in CAPEX (purchase of property, plant, and equipment). Hence for such a company net cash from investing activity will be mostly negative. Hence, a negative number is not a bad sign. You just have to see which activity is consuming cash.
Net Cash Flow From Financing Activity
Buy-back of equity shares: Rs.16,000 cash was used by the company to buy back its shares from the market in FY ending Mar’19. Hence this value is shown in negative. If the company issues new shares in the market, the value will be positive. How? By issuing shares, the company generates cash. But when the company is buying back its shares, it is doing the opposite.
Borrowings (short-term or long-term): A negative Rs.181 crore for Mar’19 means, the company has paid back its loan dues. Had they taken a new loan, the value would have been positive. For the Mar’20, the company has not borrowed any money.
Dividend Paid (including DDT): Rs.37,634 crore worth of dividends was paid by the company in Mar’20. Hence this value appears as negative. This is a cash-out flow.
Repayment of lease liabilities: When a company renews its lease (like a long-term rent agreement for office space), it has to pay upfront cash. In this case, Rs.1,062 crore was paid in FY ending Mar’20. Hence this value is shown as negative.
Interest Paid: Rs.924 is a cost originating on account of interest payment on leases, loans, etc. You will see this cost appearing as “Finance Cost” in operating activities. There it has been shown as a positive number, and in turn, adjusted here as a negative number (Rs.-924 crore) – after the cash out has actually happened.
Net Change in Cash Position
The company has generated extra cash of Rs.1019 crore from its operating, investing and financing activities at the end of Mar’20. This cash number ultimately gets added to the cash position of the company which was at the beginning of Mar’20 (Rs.7,224 crore). As a result, the cash position of the company improves to Rs.8646 core by 31-Mar’20.
The cash position of the company has increased year-on-year. This is the whole crux of doing the business. The company should be able to improve its cash position.
Final Words on Reading The Cash Flow Report
Here is a snapshot of what important things the company did in FY’2020. This is a good example of running a business:
Operating Activities:
It generated a PAT of Rs. 32,447 crore.
Net cash generated from operating activities was Rs.32,369 crore.
Investing Activities
Net cash generated from investing activity was Rs.8,565 core.
This net cash was generated by the redemption of deposits, investments, sale of assets, interest income, dividend income, etc.
New deposits and investments were also purchased at the same time.
Financing Activity (where the company used the cash generated from the above two activities)
A dividend was paid to shareholders amounting to Rs.37,634 crore.
Lease liability (Rs.1062 crore) and interest payments on loans (Rs.924 core) were also made here.
Analyzing a company’s fundamentals is a crucial step in making informed decisions about stock purchases. Here’s a step-by-step method to conduct a fundamental analysis using the company’s last five year’s financial reports:
Step 1: Gather Financial Statements
Collect the company’s financial statements for the last five years. That includes the profit & loss account, Balance Sheet, and Cash Flow Statement. Make sure the reports are audited and from reliable sources. If the reports are from the company’s official website or from reputable financial databases, it is better.
Step 2: Review the P&L Account
First, read the P&L accounts as previously discussed in this article. It will provide an overview of the company’s income, expenses, and profitability during a specific period. A five-year data study is good. Key components to review include:
Revenue (Income): Analyze the company’s revenue trends over the last five years. Look for consistent revenue growth, as it indicates a healthy and expanding business.
Gross Profit Margin: Calculate the gross profit margin by dividing gross profit by revenue and multiplying by 100. A stable or improving gross profit margin suggests the company efficiently manages its production costs.
Operating Income: Assess the company’s operating income and operating margin (operating income divided by revenue multiplied by 100) to understand how well it generates profits from its core operations.
Net Income: Examine the net income to determine the company’s overall profitability after accounting for all expenses and taxes.
Step 3: Study the Balance Sheet
First, read the Balance Sheet as previously discussed in this article. It provides a snapshot of the company’s assets, liabilities, and shareholder’s equity at a specific point in time. An analyst shall focus on the following elements:
Total Assets: Analyze the trend in total assets over the years. A growing asset base indicates business expansion and potential future growth.
Total Liabilities: Assess the company’s total liabilities to understand its debt levels and financial obligations.
Shareholders’ Equity: Calculate shareholders’ equity (Total Assets – Total Debt) to see how much of the company is owned by shareholders. Growing equity based on a time span of 5-10 years is a good health indicator.
Current Ratio: Calculate the current ratio (Current Assets divided by Current Liabilities) to assess the company’s short-term liquidity. A ratio above 1 indicates sufficient liquidity to meet short-term obligations. Read more about liquidy and solvency analysis here.
Step 4: Evaluate The Cash Flow Statement
The Cash Flow Statement presents how the company generates and uses its cash during a specific period. Focus on the following sections:
Operating Cash Flow: Analyze the operating cash flow to understand how much cash the company generates from its core operations. Positive and increasing cash flow is a positive sign.
Cash Flow from Investing: Review the investing cash flow to see how the company is investing in its business (e.g., capital expenditures, acquisitions) or divesting assets (e.g., selling subsidiaries).
Cash Flow from Financing: Evaluate the financing cash flow to understand the company’s capital structure and how it raises funds (e.g., issuing debt, issuing stock, and dividend payments).
First, read about the key financial ratios discussed previously in this article. Now, compute important financial ratios after reading the three financial reports as discussed in steps #2, #3, and #4. It will give a deeper understanding of the company’s performance and compare it with industry peers. Some key ratios include:
Assessing a company’s profitability and growth is a crucial step in fundamental analysis. This step involves analyzing various financial metrics and performance indicators to gauge how well the company generates profits and how it is positioned for future expansion. Here’s a more detailed guide on how to assess profitability and growth:
Profitability & Return
Profit Margins: Analyze the company’s profit margins, such as the Gross Profit Margin and Net Profit Margin. These margins indicate the company’s ability to manage costs and generate profits. Improving profit margins over time suggest better cost management and increased efficiency.
Operating Profit and Margin: Assess the company’s operating profit and operating margin. Operating profit represents the profit generated from the core business operations without considering other income. A rising operating margin indicates the company is becoming more efficient at generating profits from its core activities. Do a detailed analysis of the profit margin of companies.
Return on Equity (ROE): Calculate the Return on Equity (ROE) using the formula: ROE = (Net Income / Shareholders’ Equity) * 100. ROE measures how efficiently the company uses shareholders’ equity to generate profits. A high ROE indicates the company is generating significant returns for its shareholders.
Return on Assets (ROA): Calculate the Return on Assets (ROA) using the formula: ROA = (Net Income / Total Assets) * 100. ROA evaluates how efficiently the company utilizes its total assets to generate profits. Higher ROA signifies effective asset utilization.
Growth
Historical Revenue Growth: Review the company’s revenue trends over the last five years. Look for consistent growth in revenue year over year. Steady revenue growth is a positive sign, as it indicates increasing demand for the company’s products or services.
Earnings per Share (EPS) Growth: Evaluate the growth in earnings per share (EPS) over the last five years. EPS growth is a crucial metric for shareholders as it reflects the company’s ability to generate profits on a per-share basis. Consistent EPS growth is indicative of a financially healthy and shareholder-friendly company.
Free Cash Flow (FCF) Growth: Analyze the growth in Free Cash Flow (FCF) over the years. FCF represents the cash flow available to the company after covering operating expenses and capital expenditures. Positive and growing FCF indicates the company is generating ample cash to reinvest in the business or distribute to shareholders. Know more about how to calculate FCF.
Other Analysis
Industry Trends: Assess how the company’s growth compares to broader industry trends. A company may show strong growth, but if the industry is in decline, it might face challenges in the future. Read more about it here.
External Factors: Take into account external factors that could impact the company’s growth, such as changes in consumer behavior, regulatory changes, or technological disruptions. Read more about it here.
Step 7: Investigate Debt and Liquidity
Assessing a company’s debt levels and liquidity position is critical in fundamental analysis. Debt and liquidity are crucial aspects that can significantly impact a company’s financial health and stability. Here’s a more detailed guide on how to investigate debt and liquidity:
Debt Analysis
Total Debt: Start by examining the company’s total debt over the last five years. Total debt includes both short-term and long-term obligations, such as bank loans, bonds, and other forms of debt.
Debt-to-Equity Ratio (D/E): Calculate the Debt-to-Equity ratio using the formula: D/E = Total Debt / Shareholders’ Equity. This ratio assesses the company’s financial leverage or the extent to which it relies on debt financing. A high D/E ratio indicates that the company has taken on significant debt relative to its equity, which may increase financial risk.
Interest Coverage Ratio: Evaluate the company’s ability to meet interest payments on its debt by calculating the Interest Coverage Ratio. It is calculated as Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense. A higher interest coverage ratio indicates the company has sufficient earnings to cover its interest obligations, which is a positive sign.
Debt Maturity: Review the maturity profile of the company’s debt. Determine the proportion of short-term debt (due within a year) and long-term debt (due beyond a year). Heavy reliance on short-term debt could pose liquidity risks if the company faces challenges in refinancing.
Credit Ratings: Check the company’s credit ratings provided by credit rating agencies like Standard & Poor’s, Moody’s, or Fitch. Credit ratings give an indication of the company’s creditworthiness and ability to repay its debts. Higher credit ratings suggest lower default risk.
Liquidity Analysis
Current Ratio: As mentioned earlier, calculate the Current Ratio using the formula: Current Ratio = Current Assets / Current Liabilities. A ratio above 1 indicates the company can meet its short-term obligations comfortably.
Quick Ratio (Acid-Test Ratio): Calculate the Quick Ratio using the formula: Quick Ratio = (Current Assets – Inventory) / Current Liabilities. This ratio excludes inventory from current assets since inventory may not be easily converted to cash in case of financial distress. A ratio above 1 is preferable.
Operating Cash Flow to Debt Ratio: Assess the company’s ability to generate operating cash flow to service its debt by calculating the Operating Cash Flow to Debt Ratio. It is calculated as Operating Cash Flow to Debt Ratio = Operating Cash Flow / Total Debt. A higher ratio suggests the company has enough cash flow to meet its debt obligations.
Step 8: Research Management Quality
Evaluating the company’s management team and understanding its business strategy is a crucial part of fundamental analysis. The effectiveness and competence of the management team can significantly impact a company’s performance and long-term prospects. Here’s a more detailed guide on how to research management and strategy:
The Management
Management Team Background: Start by researching the background of the key executives and leaders of the company. Look for information about their education, work experience, and track record in the industry. Assess whether the management team has relevant expertise and experience in leading a company in a specific sector.
Executive Compensation: Review the executive compensation structure to ensure it aligns with shareholders’ interests. Look for companies where executive compensation is linked to performance metrics and long-term shareholder value.
The Management’s Quality
Corporate Governance: Investigate the company’s corporate governance practices. Check if the company has a diverse and independent board of directors. Independent directors can bring unbiased viewpoints and enhance corporate oversight.
Management’s Communication: Review the company’s communications with shareholders and stakeholders, including annual reports, earnings calls, and press releases. Transparent and frequent communication is a positive sign, as it indicates management’s commitment to keeping shareholders informed.
Company’s Mission and Vision: Understand the company’s mission and vision statements. These statements provide insight into the company’s long-term goals and its direction for the future.
Business Strategy: Analyze the company’s business strategy. Consider how the company plans to achieve its goals, penetrate new markets, and gain a competitive edge. Evaluate whether the strategy aligns with industry trends and macroeconomic conditions.
The Management’s Actions
Financial Discipline: Evaluate the management team’s financial discipline. Look for signs of prudent financial management, such as maintaining healthy working capital, controlling costs, and avoiding excessive debt.
Capital Allocation: Investigate the company’s capital allocation decisions. Assess whether the company reinvests profits into profitable projects, pays down debt, repurchases shares, or pays dividends to shareholders.
Innovation and Adaptability: Consider the company’s approach to innovation and its ability to adapt to changing market conditions. Companies that embrace innovation and stay ahead of industry disruptions are better positioned for long-term success.
Employee Relations and Culture: Research the company’s employee relations and company culture. A positive work environment and engaged employees can contribute to higher productivity and overall success.
Executive Compensation: Review the executive compensation structure to ensure it aligns with shareholders’ interests. Look for companies where executive compensation is linked to performance metrics and long-term shareholder value.
Environmental, Social, and Governance (ESG) Practices: Research the company’s ESG practices and initiatives. Companies that prioritize sustainability and social responsibility may have a positive impact on their reputation and long-term prospects.
Track Record of Shareholder Returns: Evaluate the company’s historical track record of creating value for shareholders. Look at stock performance, dividend history, and any share buyback programs.
Risk Management: Investigate how the management team identifies and manages various risks that the company may face, including operational, financial, and strategic risks.
Step 9: Analyze Competitive Advantages
Assessing a company’s competitive advantages, also known as its unique selling points or moats, is a critical aspect of fundamental analysis. Competitive advantages are the attributes that set a company apart from its competitors and allow it to maintain a sustainable and profitable position in the market. Here’s a more detailed guide on how to analyze competitive advantages:
Identify Key Competitive Advantages: Begin by identifying the specific factors that give the company a competitive edge. Common competitive advantages include.
Brand Recognition: A strong brand with positive consumer perception can lead to customer loyalty and higher pricing power.
Intellectual Property: Patents, trademarks, and copyrights protect the company’s unique technologies or products from imitation by competitors.
Economies of Scale: Larger companies may benefit from cost advantages due to bulk purchasing, production efficiencies, and spreading fixed costs over a larger output.
Cost Leadership: Companies that can produce goods or services at a lower cost than competitors can offer competitive pricing.
Product Differentiation: Unique features or quality that make the company’s products or services stand out in the market.
Network Effects: Platforms or products that become more valuable as more users join (e.g., social media platforms, online marketplaces).
Switching Costs: Products or services that create barriers for customers to switch to competitors due to time, effort, or financial investment.
Regulatory Barriers: Companies operating in highly regulated industries may have a competitive advantage due to barriers to entry for new entrants.
Step 10: Compare Valuation
Finally, compare the company’s valuation with its historical valuation and that of its competitors. Consider whether the current stock price reflects the company’s fundamentals and growth potential. To more about how to compare valuations, read this article on relative price valuations.
Select an Industry: Choose an industry that interests you and aligns with your investment goals. Start with industries you are familiar with or have a personal interest in.
Industry Overview: Research the industry’s size, growth rate, and key players. Look for industry reports, financial news, and government publications to gather relevant data.
Competitive Landscape: Identify major companies operating in the industry and analyze their market share, strengths, and weaknesses. Look for industry leaders and innovative players.
Industry Trends and Risks: Study recent trends, technological advancements, and regulatory changes impacting the industry. Identify potential risks that could affect companies within the sector.
Future Outlook: Consider market projections and expert opinions on the industry’s growth prospects. Evaluate how macroeconomic factors may influence the industry in the future.
By following these practical steps, an investor can gain valuable insights into different industries. Remember to start with industries you have some familiarity with. As you gain experience, you can expand your analysis to other sectors. Keep your analysis simple and focus on the key factors that impact the industry’s performance.
#7. Economic Indicators and Macroeconomic Analysis
Economic Indicators:
Key Indicators: Identify important economic indicators like GDP growth rate, inflation rate, unemployment rate, consumer confidence, and industrial production.
Industry Impact: Analyze how these indicators may affect the industry in which the company operates.
Consumer Spending: Monitor consumer spending patterns as it can impact companies in sectors like retail and leisure.
Business Investment: Assess business investment trends to understand potential growth opportunities.
Currency and Inflation: Consider how currency fluctuations and inflation can affect companies engaged in international trade and pricing decisions.
Macroeconomic Analysis:
Interest Rates: Analyze RBI’s bank policies and interest rates to understand their impact on borrowing costs and investment decisions.
Fiscal Policies: Consider government fiscal policies, such as tax rates and public spending, and how they can affect industries and companies differently.
Global Economic Trends: Be aware of global economic trends as they can influence domestic companies and industries in India.
Industry Sensitivity: Understand the industry’s sensitivity to economic cycles, with some industries performing better during expansions and others being defensive during downturns.
By analyzing economic indicators and macroeconomic factors, beginner investors can gain insights. This way, they will better understand the overall economic environment and its potential impact on the companies they are interested in.
One major limitation is the short-term market inefficiencies. In the short term, market sentiment, speculation, and trends can significantly influence stock prices, leading to temporary discrepancies between intrinsic value and market price. Timing the market based solely on fundamental analysis can be challenging. External factors, such as geopolitical events or sudden regulatory changes, can override fundamental indicators, but only in the short term.
Fundamental analysis also has limited predictive power. While it offers insights into a company’s potential, it doesn’t guarantee future performance. Unforeseen events or management decisions can alter a company’s trajectory. Additionally, some industries and sectors are cyclical by nature, making long-term projections challenging.
Psychological biases are another concern. Investors may become emotionally attached to their fundamental analysis, leading to overconfidence or confirmation bias. Thereby, they may ignore contradictory information.
Encouraging a well-rounded approach is essential to overcome these limitations. Integrating technical analysis, sentiment analysis, and considering macroeconomic trends can complement fundamental analysis. Diversifying the investment portfolio across various industries and asset classes can mitigate risks associated with individual stock selection.
Conclusion
Mastering the art of fundamental analysis equips investors with a powerful skillset to navigate the dynamic world of the stock market. By diligently following the steps outlined in this article, individual investors can confidently evaluate the financial health, growth prospects, and intrinsic value of companies on their own.
Armed with a comprehensive understanding of financial statements, key ratios, industry trends, and macroeconomic indicators, investors can make well-informed decisions to build a successful investment portfolio.
However, it is essential to acknowledge that fundamental analysis is not without its limitations. Subjectivity in interpretation, market inefficiencies, and the unpredictable nature of external factors can challenge even the most thorough analyses. As such, a prudent investor should embrace a well-rounded approach, incorporating technical analysis, sentiment analysis, and diversification to strengthen their investment strategy.
Moreover, the journey of a self-reliant fundamental analyst is continuous. Market dynamics change, and companies evolve, requiring ongoing research and adaptation. Regularly staying updated with market news, industry trends, and economic developments will enable investors to remain at the forefront of their stock evaluations.
While the path to becoming a proficient fundamental analyst may seem daunting at first, it has its benefits. Dedication, patience, and a commitment to learning will be rewarded with a deeper appreciation of the market. It enhances the potential of the investor to execute sound investment decisions. Harnessing the power of fundamental analysis, investors can confidently navigate the complex financial landscape. They can unlock the doors to a world of exciting investment opportunities and long-term financial growth.
How To Do Fundamental Analysis of Stocks By Oneself?
Let’s explore the impact of multiple health claims on insurance premiums. Discover how past claims history can influence your policy costs. Gain insights into managing your health insurance expenses more efficiently. Learn to navigate the intricacies of insurance and make informed decisions for a secure financial future.
The utility of a health insurance policy is unquestionable. But in this article what we’ll discuss is a hidden aspect of these health covers. As a policyholder, we must know how to deal with it in advance.
A person is anguished by the steep rise (40%) in his health insurance premium. His health insurance premium becomes due in September of each year. In July’23, he got a pre-intimation letter from Tata Aig that, for the forthcoming year, his annual premium will increase by more than 40%.
During the previous year (2022), the person made several health claims (about 10 nos), during a span of 10 months. The total claim amount in the policy tenure of 2022 was 22% of the total claim amount. All the claims were honored by Tata Aig swiftly and the person was more than happy with his policy.
This article aims to unravel the complexities of health insurance premiums, with a specific focus on the impact of multiple health claims. By analyzing the above case and examining the factors that insurance companies consider when adjusting premiums.
Our aim is to provide insights into the correlation between claims history and premium adjustments. Furthermore, we’ll also learn how to avoid the impact of claims on the annual premium.
Insurers utilize a meticulous process to calculate premiums. They take various factors into account to arrive at a fair and sustainable amount. The calculation of health insurance premiums is a dynamic process that relies on statistical analysis, actuarial science, and risk assessment.
Age: Age plays a significant role in premium calculation. It is because the likelihood of health-related issues tends to increase with age. Younger policyholders usually pay lower premiums, whereas older individuals might have higher premiums.
Medical History: A policyholder’s medical history is scrutinized to gauge the risk of potential future claims. Pre-existing conditions or a history of health issues can result in higher premiums or specific exclusions.
Coverage Type: The extent of coverage desired by a policyholder impacts the premium. Comprehensive plans with wider coverage typically come with higher premiums.
Geographic Location: Medical costs can vary significantly based on the region, affecting premium amounts. For example, medical expenses in a Tier-1 city will be higher than in a Tier-2 city.
Policy Duration: Longer policy durations may offer benefits such as lower premiums, providing more extended coverage stability.
Lifestyle Habits: Certain lifestyle choices like smoking or excessive alcohol consumption may lead to higher premiums due to increased health risks.
Co-payment: Opting for higher co-payment can lead to reduced premiums. As policyholders agree to share a portion of the expenses, lower premiums are possible this way.
Hence, making multiple claims within a narrow span of time can have an impact on future premium amounts. Insurers interpret frequent claims as a potential indicator of a policyholder’s susceptibility to illnesses increasing the likelihood of future claims. Consequently, the insurer may adjust the premium to account for the perceived higher risk.
For policyholders who have experienced multiple health claims, managing premium adjustments can be a task. It is essential to strike a balance between comprehensive coverage and cost considerations. The idea is to ensure continued protection without undue financial strain. What policyholders can do to manage their health insurance costs?
Review Policy Coverage: The current coverage can be adjusted to lower the premium. Evaluate if all existing add-ons and riders are still relevant. Eliminating unnecessary benefits can help reduce premiums.
Opt for Higher Deductibles (Copayment): Selecting a higher deductible can lower the premium. The deductible is the amount the policyholder pays as its own contribution during the settlement of the final bill. Though it is essential to ensure that the deductible remains affordable in the event of an emergency.
Having Multiple Health Policies: If one insurer does not like multiple claims, then as a policyholder we should consider keeping more than one policy. This was it is possible to distribute the claims between say two companies.
By implementing these practical tips a policyholders can navigate the challenges of managing health insurance costs after multiple claims.
Suppose you are on a telephone call your my current health insurance provider. What you can tell them so that they will lower your health insurance premium?
First of all, it is essential to be polite, confident and prepared. Here’s a step-by-step guide on what to say during the conversation:
State Your Purpose: Clearly state the reason for your call – to discuss the possibility of lowering your health insurance premium.
Highlight Loyalty: Mention how long you have been a policyholder with their company. Give them the impression that you value your relationship with them. Emphasize that you have been making regular premium payments.
Claims History: Mention why your claim has spiked in recent times.
Healthy Lifestyle: If applicable, talk about any positive lifestyle changes you (your family) made. Give examples like quitting smoking, adopting healthier habits, or engaging in regular exercise. Explain that these changes may contribute to better health and reduced risk.
Policy Review: Discuss your current policy and mention any optional coverages or riders that you may be willing to remove to lower the premium. Take their advice to ensure that essential coverage is maintained.
Compare with Competitors: Politely mention that you’ve been exploring other health insurance options and have found some competitive premiums elsewhere. Let them know you would prefer to stay with their company.
Ask for Suggestions: Request their advice on how you can lower the premium while retaining necessary coverage. Ask if they have any discounts or cost-saving options available.
Thank Them: Regardless of the outcome. Thank the representative for their time and consideration. Be respectful, even if they are unable to lower the premium as much as you hoped.
What care must be taken to switch the health insurance policy to a new health insurance provider?
Switching health insurance policies to a new provider requires careful consideration and attention to detail. Here are some essential steps and precautions:
Research and Compare Plans: Compare coverage benefits, premium costs, network hospitals, and claim settlement ratios. Check customer reviews about the new insurance provider.
Policy Overlaps: Ensure that there is no overlap between your current policy and the new policy to avoid paying for redundant coverage. Plan the switch to align with the end date of your existing policy.
Waiting Periods: Be aware of any waiting periods that may apply to the new policy, especially for pre-existing conditions. Understand the waiting period requirements for specific treatments or ailments before making the switch.
Medical Underwriting: If you have pre-existing conditions or a history of claims, check if the new insurer requires medical underwriting. Disclose all relevant health information truthfully to avoid claim rejection later.
Portability Option: If you wish to switch without losing continuity benefits (like waiting periods and no-claim bonus), inquire if your current insurer offers a portability option. Porting allows you to transfer your policy to a new insurer without losing certain benefits.
Cancellation Procedure: Follow the proper cancellation procedure with your current insurer. Provide written notice and ensure that you receive a confirmation of policy cancellation.
We’ve shed light on essential aspects of health insurance premiums. We’ve seen the impact of multiple health claims on insurance premiums. We explored how insurers calculate premiums based on various factors, including claims history, and how making multiple claims within a short period can influence future premium amounts.
To effectively manage health insurance expenses, policyholders should evaluate their coverage needs. They can compromise on co-payments etc to lower the annual premium amount.
Understanding the intricacies of health insurance empowers individuals to strike the right balance between comprehensive coverage and affordability.
Health insurance premiums are influenced by various factors, and multiple health claims can have a significant impact on your insurance premiums. Here’s how it works:
Underwriting and Risk Assessment: Insurance companies assess the risk of insuring an individual or a group based on various factors, including their age, gender, pre-existing health conditions, lifestyle choices, and medical history. When you apply for health insurance, the insurer may ask you to disclose your medical history and any pre-existing conditions. If you have a history of multiple health claims, it signals a higher risk to the insurer.
Premium Determination: The premium you pay for health insurance is based on the insurer’s estimation of the likelihood that you will make claims in the future. People with a history of frequent health claims or chronic medical conditions are more likely to continue making claims, which increases the insurer’s financial risk.
Higher Premiums: If you have a history of multiple health claims, insurance companies are likely to charge you higher premiums to compensate for the increased risk they are taking by insuring you. These higher premiums are often referred to as “rated” or “loaded” premiums.
Exclusions and Waiting Periods: Insurance companies may impose exclusions or waiting periods for specific pre-existing conditions or treatments if you have a history of multiple claims. During these waiting periods, the insurer may not cover certain medical expenses related to those conditions.
Policy Type: The type of health insurance policy you have also plays a role. If you have a group health insurance policy through your employer, the impact of multiple health claims may be less significant because the risk is spread among a larger pool of people. However, if you have an individual or family health insurance policy, the impact can be more pronounced.
Renewal Terms: Insurance premiums can change when your policy is up for renewal. If you’ve had multiple claims during the previous policy term, your insurer may increase your premiums at renewal.
State Regulations: State regulations can influence the extent to which insurers can adjust premiums based on health claims history. Some states have strict regulations that limit the extent to which insurers can charge higher premiums based on pre-existing conditions.
To mitigate the impact of multiple health claims on your insurance premiums:
Consider shopping around for different insurance plans to find the best coverage and rates.
Maintain a healthy lifestyle to reduce the risk of future health issues.
Consult with an insurance agent or broker who can help you find suitable coverage options.
Understand the terms and conditions of your policy, including any exclusions or waiting periods.
