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Results analysis: Some key points - Views on News from Equitymaster
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  • Apr 19, 2007

    Results analysis: Some key points

    The results season has arrived and scores of analysts on the street must have kept their analytical tools ready so that they are able to scour through reams and reams of papers and scrutinize every minute detail there is. This ritual is done to help them weed out the winners from the losers, or in other words, identify companies that are likely to continue to grow or have entered into a new growth phase and discard the ones, where business prospects do not look attractive enough vis-a-vis the valuations. Given the large number of variables involved, this does look a daunting task. In this write up, we have made an attempt to identify some key parameters one should look at while trying to analyse a company's financial results.

    Operating margins: This is one metric that most of the analysts pay extremely close attention to. After all, it is very important to know how the firm has performed in its core area of operations. Here, while the analysts may settle for a slower than expected growth in operating profits, any fall in operating margins will not be easily spared. This is because the latter has a more severe impact on the profits of the company and has the potential to completely wipe off the benefits from topline growth. Just to put things in perspective, a 200 basis points decline in revenue growth of say 10% at constant margins (20%) will decline your operating profit growth by the same 200 basis points. On the other hand, a 200 basis point contraction in operating margins for a company with the same revenue growth and OPM as before will actually lower the operating profit by 1%. Little wonder, investors take a very critical view of a contraction in operating margins. To make matters worse, lower the operating margins, the severe the impact. From a business point of view, fall in operating margins signifies either the inability of the company to pass on the cost hike to its customers or intensifying competition or may be both. Both are dangerous signs and investors need to be wary of the same.

    Financial charges: Firms use a mix of both debt as well as equity to meet their capital needs and since the cost of funds for the former is usually lower and interest on it is paid out before taxes, it is believed that a company should have some amount of debt on its books. This is because although it provides leverage during good times and helps in maximizing profit, during bad times, it can make a bad profit scenario look worse. Hence, moderation should be the buzzword here. It is this very moderation that the investor should watch out for while analysing the interest expense for a firm. Firms with good management and strong business fundamentals use their debt judiciously, not allowing it to go out of control. Thus, if a firm's interest expense is witnessing a steep rise, it is a potential 'red flag' and investors should guard against it.

    Extraordinary gains/losses: From time to time, firms incur certain gains or losses that are largely one time in nature and are not likely to appear consistently year on year. It is very important that an investor takes notice of the same and treats it appropriately. A good idea would be to not include them while comparing different year profits for it will give a skewed picture. It is also pertinent to add that some companies might show the same at different places and this would require more than just the basic skill to weed them out.

    Net profits: And finally the bottomline, pun intended. This figure is an aggregation of everything that has happened with the firm in the period under consideration. The two key parameters being its operating performance and its financing charges. Other factors like tax rates and duties applicable are also important but they are more a result of some external changes and the ability to control them is not really in the firm's hands. The important thing is how does it do on those parameters, which are in its control. If its growing its net profits at a rate, which is consistent with its past performance and not facing too much pressure on margins, then I think there is little need to chuck it out of your portfolio. However, any negative surprises needs to be gone deeper into so as to enable one to find out whether it just a temporary phenomena or some deeper malaise.

    Having underlined the key parameters to look for while analysing a company's financial performance, it is worth noting that it will be foolhardy to make a 'buy' or 'sell' decision based on just one quarter's performance. It should at best be treated as an exercise to determine whether a deeper examination (like reviewing balance sheets & cash flow statements or meeting with the management) is required or one can move ahead as there seems to be no major issues with the company currently.



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