How To Do Financial Analysis

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How to analyse a company

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After identifying the right industry to park your money, you should lay your hands on the right company. Some parameters that will help you analyse a company.

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After you have decided that it is the right time to invest in and identified the right industry to park your money, you should lay your hands on the right company. As Peter Lynch says, "Identifying the right industry but the wrong company, is like marrying into the right family but the wrong girl."

Here are eight financial and three non-financial parameters that you should look into when you invest in a company.

Return on Capital employed: This refers to the amount earned by the company on the total funds employed in business. The capital means both equity capital and loan capital. Equity capital would, of course, include reserves as well. Return would mean profit after tax plus interest on long-term funds, adjusted for tax. This measures the productivity of money and is the closest measure of finding out the underlying economics of the business. Higher the ROCE, better for the investor. At minimum, ROCE should be equal to the Weighted Average Cost of Capital (WACC) of the company. The WACC is the rate of return that equity shareholders and debt holders put together want to earn.

Return on equity: The return on equity measures the total return earned on the shareholders fund invested. It is the ratio of profit after tax to shareholders funds. Over the long term, the value of a company would move in lock step with the return on equity. Higher the ROE, better for the investors. Generally, ROE is higher than ROCE since the cost of debt is generally lower than ROCE, thus resulting in equity holders enjoying a higher share in the total returns pie.

Historical sales growth: This indicates how the company has been able to grow its business over the long term. Compared with the industry growth rate, this would give an indication of whether the company is increasing its market share or not. Also, it would help in finding out whether the business is in the growth or maturity phase and in understanding the seasonality of the business and, interpreting growth of the recent past, accordingly.

Free cash flows to shareholder: Business is not about booking accounting profit; hence cash surplus is more important than accounting surplus. Free cash flow is found out by deducting the upcoming maintenance capital expenditure from the cash from operations.

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