In today's blog, we are going to keep discussing about how to check a company's financial health and look at six important metrices that every investor should consider about before investing in a company. This is an intermediate guide, which means we will explore a few more advanced parameters. In the last blog, we covered the basics, focusing on simple metrics. So let's discuss.
PEG Ratio
The full form of PEG ratio is Price to Earnings growth ratio. In simple words, it is one of the stock price value-measuring methods. It can be thought of as an improved form of P/E Ratio since it, too, shows how much earnings a company would have in the future.
Most people are aware of and familiar with the P/E Ratio, but very few know the PEG Ratio. This is only because it is more complicated to understand the PEG Ratio, and each person tends to view it differently. Others would say that if the ratio is more than 1, it's too pricey. If less than 1, it's cheap—no more, no less. They probably do not get the ratio concept well or remember just this simple rule without really knowing the idea and the details behind it.
It is calculated by taking the P/E Ratio and dividing it by the Earnings Growth Rate. Again, the P/E Ratio was discussed in the previous blog post, so you can refer back to that article if you would like to read further on that topic. The Earnings Growth Rate is the rate at which a firm's net earnings are expected to increase in the future. Forecasting plays a crucial role here, which is why the PEG Ratio for the same company can vary significantly depending on the method of forecasting. For instance, one person would expect that its profits would be 5%, while another expects an 8% growth rate. It is this difference of growth rate which causes the discrepancies in the PEG Ratio of the same company.
EV/EBITDA Ratio
The EV/EBITDA ratio helps in determining the worth of a company based on its earnings before interest, taxes, depreciation, and amortization. It tells us how much the company's total value is for each Rs 1 of EBITDA.
Enterprise Value (EV) is an enhanced or extended version of market capitalization. Its formula is: Market Cap + Debt - Cash. In this, the debt component is added, and cash is deducted. This gives the true value of a company.
If this ratio is greater than 1, it means that for every Rs 1 of EBITDA, the company's enterprise value is greater than 1, indicating that the company is overvalued. On the other hand, if the ratio is less than 1, it means that for every Rs 1 of EBITDA, the company's enterprise value is less than 1, suggesting that the company is undervalued.
Cash Flow from Operations
Cash is very essential for any company. A company needs cash to keep it going. That is why many investors look to invest in companies that have much cash. If a business fails to generate cash through its direct revenues or if the cash flow from operations is negative, this is a red flag for the business. Due to this reason, cash flow from operations is considered one of the most significant measures.
The problem is that most people cannot differentiate between Sales and Cash Flow from Operations. Most confuse them with each other. They believe that sales refer to the revenues made through sales, whereas Cash Flow from Operations means how much cash was realized from the sales of the company's products. However, it's more different than one thinks.
- Sales: The aggregate of the units sold by an organization-with or without the realization of cash by the organization-again is known as sales. Technically it is termed as "booked sales".
- Cash Flow from Operations encompasses only that amount of sales of the units for which the company has sold and for which it has collected the amount of cash.
This is a big difference. Cash Flow from Operations is usually lower than the total revenue since the company may not have received cash for all its sales. Some customers will wait to pay or may not pay at all. This makes Cash Flow from Operations an important measure, since it only reflects the value of sales which the company has actually received cash for.
Cash flow from operations is an indicator that tells the extent to which cash a business entity has generated or utilized through its main business operations. In simple words, it shows whether the company has earned or spent the cash from its core business.
Pledged Percentage
The pledged percentage is the part of shares that the company's promoters have promised as security for a loan. This means the promoters have pledged a certain percentage of their shares to secure a loan from a bank or financial institution. If the company fails to pay back the loan, the bank or financial institution can sell those promised shares to get their money back.
The pledged percentage is a number that matters as it can be risky for the company if it is too high. In case the loan is not repaid on time, the shares that the promoters pledged may get sold and hence reduce their ownership. Therefore, the investors should ensure that the pledged percentage is low, ideally at 0% or at most 2%.
Auditor's Opinion
Every company appoints an auditor every year, which checks the company's financial statements. The basic meaning of audit is to ensure whether there exists any error or misstatement in the financial statements or not. On the basis of such an audit of the financial statements, the auditor prepares a report and gives an opinion on the financials. An auditor can have three of the major opinions: unmodified, qualified, or adverse. The auditor is going to issue one of those three.
- Unmodified Opinion: Means that financial statements are sound and contain no serious weaknesses.
- Qualified Opinion: There are some problems or differences, but they are not serious enough to change the financial statements as a whole.
- Adverse Opinion: This happens when there are significant issues or mistakes in the financial statements and they do not reflect a fair and accurate picture of the company's financial condition.
Contingent Liabilities
Contingent liabilities are liabilities that the company’s management believes might occur in the future. This means these liabilities do not actually exist yet, but management thinks they may arise, and the company may need to pay for them in the future. Therefore, the company discloses them in its financial statements. These will not appear on the balance sheet because the balance sheet only includes actual liabilities. Instead, contingent liabilities will be shown separately below the balance sheet.
Examples of contingent liabilities include lawsuits or guarantees. For example, if a company is involved in a lawsuit and believes it may lose and be liable to pay a penalty or compensation, it can indicate the possible amount in its contingent liabilities. Although the company has not paid anything yet, it expects that this liability could occur in the future based on the case's outcome.
That's why investors should look at contingent liabilities to see if the company might have potential losses later. These losses could harm the company's cash flow or profits. By checking contingent liabilities, investors can understand the possible financial risks that may come up, which helps them make better decisions about the company’s future stability and profit.
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