How to Know if a Business is Improving or Not
I have created a simple system for myself, to figure out whether a business is improving or not, over a period of time.
The best place to look at, is the profit and loss account statement of the company.
This is the simplest of all statements, that a company releases every year.
The first thing I look at, is the revenue from operations.
I only want to look at the revenue that the company is generating from operations.
I exclude 'other income' from total revenue.
I want to know, how much the company is making by selling a product or a service.
From this revenue, I reduce the 'cost of goods sold' or 'cost of providing the service'.
If it's a manufacturing company, its 'cost of goods sold'.
If it's a service providing company, then it is 'cost of providing the service'.
What I get, is the gross profit of the company.
The higher the gross profit margin, the better.
I look at past 10 years of history of the company.
I want to know if the gross profit margin is improving or not.
That tells me, the company has got pricing power.
It tells me, the company is not affected by competition, and the business is improving.
That's the gross margin.
Its gross profit divided by the revenue from operations.
Then there are a couple of expenses that are deducted from the gross profit.
One is depreciation on fixed assets.
Second is: Selling, General, Admin, R&D expenses.
I remove both of these expenses from the gross profit.
What I get is the operating profit of the company.
I divide it by revenue from operations.
I get the operating margin of the company.
If we see a trend where operating margin is growing over a period of time, at least the past 10 years, that means the businesses improving.
From the operating profit, I deduct the interest expense.
Let's say the company has taken on some debt.
Generally, I don't look at leveraged companies.
But if the company has little bit of debt, it will have some interest expense.
So, from the operating profit I reduce the interest expense.
What I get, is the pretax operating earnings of the company.
It's a very important number, because I compare this number with the equity of the company.
I compare this number with the invested capital of the company.
I also compare this number with the market value of the company.
If the market value of a company is say, INR 4,000 crores, and the pretax operating earnings are INR 400 crores, then in that case, your pretax operating yield is 10%.
If fixed deposits in a bank are offering me 5%, and if this company is offering a 10% yield, and that too a growing yield, then it's probably an undervalued company.
Hence, pretax operating earnings is very important.
To this number, we have to add the 'other income'.
Remember, when we looked at the revenue, we excluded 'other income', because we only wanted to see revenue from operations.
When I add the other income to the pretax operating earnings, what I get is, the profit before tax.
From this profit, I deduct the taxes.
I finally get the profit after tax.
That gives me the net margin.
Profit after tax, divided by the revenue from operations.
If this margin is improving over a period of time, I am looking at a good business.
It means the management has been doing something in the right direction.
If we look at these numbers over a 10 year period, for a particular company, and then compare these numbers with other companies in the same sector, then we will know which company is better, in that sector.
Analysing the profit and loss account is a very simple exercise, that any retail investor can do, to figure out whether the business is improving or not.
If you find a business where the gross margin was 40%, 10 years ago, and now it has come down to 23%, you have a clear signal that there is something wrong with the company.
Maybe the company has lost pricing power.
Maybe the raw material prices have increased.
Something is wrong with the business.
But, if you find a business where the gross profit margin was 40%, 10 years ago, and now it is 63%, you know that the company is doing something good.
Look at the profit and loss account statement.
That gives us an idea as to whether the business is improving or not.
Rohit Musale, CFA
3 January 2023