Part 8: Company Analysis - Financial Analysis – NISM Series XV Research Analyst Short Notes

Financial Analysis – NISM Series XV Research Analyst Short Notes (Part 8)

This is Part 8 of the NISM Research Analyst Short Notes series on PassNISM.in. Financial analysis is the quantitative foundation of fundamental research. A research analyst does not need to be an accountant, but must be able to read, interpret, and analyse financial statements accurately.

This chapter covers the balance sheet, profit and loss account, cash flow statement, financial ratios, and comparative analysis — all heavily tested in the NISM Series XV exam.

Introduction to Financial Statements

Companies publish four primary financial statements:

1. Balance Sheet

A snapshot of the company's financial position at a specific point in time. It shows assets, liabilities, and shareholders' equity at the end of the reporting period.

Accounting Equation: Assets = Liabilities + Shareholders' Equity

2. Statement of Profit and Loss (P&L)

A summary of performance over a period (quarter or full year). It shows revenue earned, expenses incurred, and profit generated during that period.

3. Statement of Changes in Shareholders' Equity

Records changes in the equity portion of the balance sheet — due to profits earned, dividends paid, new shares issued, buybacks, and other comprehensive income items.

4. Cash Flow Statement

Summarises all cash inflows and outflows during the period, categorised into three activities: operating, investing, and financing.

Balance Sheet — Key Line Items Assets

Assets are resources owned by the company that are expected to generate future economic benefits. They are divided into:

• Non-Current Assets — Long-term assets that provide benefits over more than one year. Examples: plant and machinery, land and buildings, intangible assets (patents, brands), long-term investments
• Current Assets — Assets expected to be converted to cash within one operating cycle (typically one year). Examples: cash and bank balances, trade receivables, inventories, short-term investments

Liabilities

• Non-Current Liabilities — Obligations payable beyond one year. Examples: long-term borrowings, deferred tax liability
• Current Liabilities — Obligations payable within one year. Examples: trade payables, short-term borrowings, current portion of long-term debt

Working Capital

Working Capital = Current Assets − Current Liabilities

Working capital represents the money locked in the day-to-day operations of the business. Efficient management of working capital is critical — too much capital tied up in inventory or receivables reduces free cash flow.

Contingent Liabilities

Contingent liabilities are potential obligations that depend on the outcome of a future uncertain event. Example: a pending court case. If the company loses the case, it would incur a real financial liability. Contingent liabilities are disclosed in the notes to financial statements and can be significant enough to affect investment decisions.

Profit and Loss Account — Key Line Items Revenue from Operations

Revenue is the amount earned from selling goods or services — the company's core business activity. It is also called turnover or sales.

Other Income

Income from non-core activities — interest earned on investments, profit on sale of assets, dividend income from subsidiaries. Analysts adjust for other income to assess the core business performance separately.

Key Expense Line Items for Manufacturing Companies

• Cost of Raw Materials — Amount of raw materials actually consumed in production during the period
• Purchase of Stock-in-Trade — Goods purchased for resale without any further processing (trading goods)
• Changes in Inventory of Finished Goods and WIP — Increase in inventory = production exceeds sales; Decrease = sales exceed production
• Employee Costs — Salaries, wages, benefits, stock-based compensation expense, and staff welfare costs
• Depreciation — Gradual reduction in the book value of tangible assets due to use, ageing, and obsolescence
• Amortisation — Gradual write-off of intangible assets (patents, licences, goodwill) over their useful life
• Finance Costs — Interest paid on borrowings

Tax Expense (Indian Companies)

Tax expense for an Indian company includes three components:

• Current Tax — Tax payable under the Income Tax Act for the current year
• Minimum Alternate Tax (MAT) — Applicable when a company's tax under normal provisions is very low due to exemptions
• Deferred Tax — Timing difference between tax and accounting treatment; can be an asset or liability

Earnings Per Share (EPS)

EPS = Net Profit Attributable to Equity Shareholders / Weighted Average Number of Outstanding Shares

EPS is one of the most widely tracked metrics in equity research. Rising EPS usually drives stock price appreciation.

Key Profitability Metrics from the P&L

Cash Flow Statement

The cash flow statement reconciles the opening and closing cash balance. It has three sections:

Operating Cash Flows

Cash generated or used by the company's core business operations. This corresponds to items in the P&L (adjusted for non-cash items like depreciation and changes in working capital). Healthy companies should consistently generate positive operating cash flows.

Investing Cash Flows

Cash flows related to investment in or disposal of long-term assets (balance sheet items). Capital expenditure (purchase of machinery, buildings) is typically the largest outflow here.

Financing Cash Flows

Cash flows related to how the company is funded — borrowings raised or repaid (debt), dividends paid, shares issued or bought back (equity).

Free Cash Flow to Firm (FCFF) = Operating Cash Flow − Capital Expenditure − Tax benefit on interest payments

Commonly Used Financial Ratios Profitability Ratios

Return Ratios

Liquidity Ratios

Leverage Ratios

Efficiency Ratios

DuPont Analysis — Decomposing ROE

The DuPont framework breaks ROE into three components to identify what is driving or limiting return on equity:

ROE = Net Profit Margin × Asset Turnover × Equity Multiplier

Where:

• Net Profit Margin = Net Profit / Revenue (profitability)
• Asset Turnover = Revenue / Total Assets (efficiency)
• Equity Multiplier = Total Assets / Shareholders' Equity (financial leverage)

A company can have high ROE because of superior margins, high asset efficiency, or high financial leverage — the DuPont analysis helps distinguish between these drivers.

Other Major Points for Comparison

• Peer Comparison — Comparing ratios against competitors in the same industry to identify relative strength or weakness
• Dividend and Earnings History — Consistency of dividends signals financial health; earnings growth history shows track record
• History of Corporate Actions — Bonus issues, buybacks, and rights issues provide insights into management's capital allocation philosophy
• Ownership and Insider Trades — Changes in promoter holding and insider buying/selling can signal management confidence or concern

Capital Expenditure Formula

Capital expenditure (capex) is not directly shown as a single line in the income statement. It can be derived as:

Capex = Closing Fixed Assets − Opening Fixed Assets + Depreciation for the Year

Quick Revision Points — Financial Analysis

• Balance sheet = snapshot at a point in time; P&L = performance over a period
• Working Capital = Current Assets − Current Liabilities
• EBITDA = Net Profit + Finance Cost + Tax + Depreciation + Amortisation
• EBIT = EBITDA − Depreciation − Amortisation (Operating Profit)
• Higher EBITDA margin = more efficient operations
• ROE measures return on equity capital; ROCE measures return on total capital
• Higher Interest Coverage Ratio = safer ability to service debt
• Debt/Asset ratio is better than D/E for comparing financial leverage across companies
• DuPont: ROE = Profit Margin × Asset Turnover × Equity Multiplier
• Contingent liabilities are disclosed in notes — may become real obligations
• Operating cash flow should be positive and greater than net profit for quality earnings
• Capex = Closing Fixed Assets − Opening Fixed Assets + Depreciation

Next in the Series

Part 9 of our NISM Research Analyst Short Notes series covers Corporate Actions — dividends, rights issues, bonus issues, stock splits, buybacks, mergers and acquisitions, spin-offs, delistings, and share swaps. These are important exam topics and also essential knowledge for working as a research analyst.

Practice financial ratio calculations with mock tests at Research Analyst Free Mock Test.