Thursday, 19 July 2012

How to analyze the financial health of a company

Investing in stocks is the best method of beating inflation, but if you do not have much care you should pay for it with your hard earned money. One of the important strategies of investing in shares is investing shares of strong company and keeping it for a long time. How an ordinary man can analyze the strength of a company? What does the strength mean? Is Iron and Steel Company is stronger financially than cotton textile industry? If not, what method one can analyze the strength of a company to invest in its shares? Here, the strength of a company means financial strength. How can we determine the financial strength of a company? There are so many ratios to be analyzed to reveal the financial health of a company. The following 5 parameters can enough to know the financial strength of a company.

Earnings per Share (EPS)

This is the prime parameter to determine the financial health of a company.  EPS determines the profitability of a company. It is the net profit (after deducting Dividend to preference shares) available to each unit of shares. One can easily determine the EPS by dividing the net profit – dividend to preference shares by the number of shares.

For example, The net profit of a company is 100000 and dividend to preference shares for the year is 10000, and if there are 1000 shares allotted by the company, the  Earnings Per Share is (100000-10000)/1000 = 90.

Net Sales

This is the next financial parameter to determine the financial strength of the Company. Net Sales are the total sales (Gross Sales) deducted by sales returns, allowances and discounts or reduction allowed against sales. The formula for deriving net sales is Gross Sales – sales return- discounts, allowance and reductions.

Book Value per share (BVPS)

The next financial parameter is the book value per share. BVPS is also known as net asset per share or equity per share which shows whether the shares of a company is undervalued or overvalued. The BVPS is calculated by dividing the net asset (Assets – Liabilities) by the total number of shares.

Examples: A company having asset of 10, 00,000 and all outside liabilities (liability excluding equity share capital) are 500000 and there are 1000 shares. The BVPS is (1000000-500000)/1000 = 500.

Return on invested Capital (ROIC)

ROIC determines how well a company uses its investments to make a profit. It is a ratio of working capital and fixed assets with net operating profit of the company. This net operating profit also considers by reducing tax applicable to the company. So the formula, for deriving ROIC is Net Operating Profit after Tax / (working Capital + Fixed Assets).

Debt to Net Income Ratio

This is also known as debt to Net profit ratio. It tells us how many years required paying off a loan with the net profit of a company. This means the required time to pay off debts without much difficulty. I f the result is 3 (years) or less than 3 one can determine that the company has a strong financial health. Debt to Net profit Ratio = Total debt / net profit.

With the help of the abovementioned 5 financial parameters, one can decide whether he can buy the shares of a company and can make a profit out of them or not.  You must analyze the abovementioned parameters for about 10 years. If, EPS, Net Sales, BVPS and ROIC should increase 8% to 12% every year and Debt to net income ratio must be equals to 3 or less than 3, one can determine, the company is financially strong. If Invest in such companies the possibility of loss will be remarkably less, even if, the past performance of a company may or may not reflect in future. To know the profitability of a share, there are certain other conditions also to be evaluated, but these financial ratios are remarkably much essential to analyze the financial health of a company.

Financial health of a company

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1 comment :

  1. [...] Return on invested capital (ROIC) and Debt to Net Income ratios are the parameters which helps to analyze the financial health of a company. We can check all these of a company for the last few years, say 10 -12 years. But what is the [...]