The Rationale Analysis of Share Market

Md. Badrul Millat Ibne Hannan: Suppose, you have BDT 5.00 million. You want to invest this surplus money in a profitable business. But you don’t have enough time, man, machine and organization to establish a business. As you are a busiest one and lead a full-time family with four members. Recently, banks have cut interest rate which does not satisfy you. Beside these, you are a risk taker person. Finally, you have taken a decision to invest this surplus money partially in banks in the form of FDR and partially in the capital market. Now the question is which company’s share do you buy and which indicators should you consider? Here, some important techniques are discussed for the selection of the companies which share you want to buy.

The stock market serves two very important purposes. The first is to provide capital to companies that they can use to fund and expand their businesses. By offering stock shares instead of borrowing the capital needed for expansion, the company avoids incurring debt and paying interest charges on that debt.

The secondary purpose the stock market serves is to give investors – those who purchase stocks – the opportunity to share in the profits of publicly-traded companies. Investors can profit from stock buying in one of two ways. Some stocks pay regular dividends (a given amount of money per share of stock someone owns). The other way investors can profit from buying stocks is by selling their stock for a profit if the stock price increases from their purchase price.

Now the question is why do people invest in stock market? Or why do people purchase stock? Answer will be many ways-one of the reasons is buying shares of companies implies that the investor owns a part of that company, thereby allowing him to enjoy the profit that the company makes. The part of the company owned is equivalent to the percentage of shares that he has purchased. As a partial owner of the company, he will be kept informed about company news and updates.

Before investing in Capital Market, investors should acquire some analytical knowledge about share market. An investor can analyze the shares the following ways-

Guide to Financial Statement Analysis
The main task of an analyst is to perform an extensive analysis of financial statements. we will break down the most important methods, types, and approaches to financial analysis.

This guide is designed to be useful for both beginners and experienced for long time in share market, with the main topics covering:
(1) income statement,
(2) balance sheet,
(3) cash flow, and
(4) rates of return.

Income statement analysis
Most analysts start their analysis of financial statements with the income statement. Intuitively, this is usually the first thing we think about with a business…we often ask questions such as, “how much revenue does it have, is it profitable, what are the margins like?”

In order to answer these questions, and much more, we will dive into the income statement to get started. There are two main types of analysis we will perform: vertical analysis and horizontal analysis.

Every listed company prepares the Financial Statement mandatorily for regulatory purposes and submits it to the stakeholders it is also available in website of those company. As analytical elements are available. So we can analyze it easily. Graph shown above is taken from a listed trading company’s partially modified financial statement.

Suppose, ABC company earns revenues from selling goods in the year-2016 BDT-3000, 2017 BDT-4000, 2018 BDT-5000 and its Cost of Goods Sold (COGS) 2500, 3000, 3200 BDT respectively. If we analyze vertically- in the year 2016 COGS is 83% of Revenue, 2017 COGS is 75% of Revenue, 2018 COGS is 64% of Revenue. Formula-(COGS/Revenue) X100 (percentage shown is the mid of graph). Gross Profit is the difference between Revenue and COGS. Here , we should keep it in the mind- the more Cost of Goods Sold (COGS), the less possibility of Gross Profit. From the partial analysis, we can assume about net profit or net loss.

Accounting for Cost of Goods Sold
IFRS and US GAAP allow different policies for accounting for inventory and cost of goods sold. Very briefly, there are four main valuation methods for inventory and cost of goods sold.
1. First-in-first-out (FIFO)
2. Last-in-first-out (LIFO)
3. Weighted average

Under FIFO, COGS consists of finished inventory units that were produced first and thus consist of costs incurred first, whereas under LIFO, COGS consists of finished inventory units that were produced last and therefore consists of later or most recent costs

Though Last-in-first-out (LIFO) is prohibited under IFRS and ASPE but it is permitted under US GAAP.

A higher increase in the cost of goods sold can be on account of either increased sales volume or higher input cost. Furthermore, it is evident that the cost of goods sold for the company improved as an outcome of increased sales volume. This is because the sales increased during the year.

Now, the sales value would have increased significantly if the company would have made sales at the previous sales price. But that is not the case as sales value did not change to a greater extent. This hints towards the fact that incremental sales have been made at a price lower than the sales price.

The second step is more critical than first step. Depreciation is one of the main changing factors for Net Profit or Net Loss. It is another topic but when any investor wants to sustain in long time for earning profit from share markets depreciation calculation and analysis along with amortization is a better for gain.

Again, from the graph -depreciation is 13% of Revenue in 2016, 11% in 2017, 10% in 2018. Formula-(Depreciation/Revenue) X100.

Sales revenue is the income received by a company from its sales of goods or the provision of services. In accounting, the terms “sales” and “revenue” can be, and often are, used interchangeably to mean the same thing. It is important to note that revenue does not necessarily mean cash received. A portion of sales revenue may be paid in cash and a portion may be paid on credit, through such means as accounts receivables.

Sales revenue can be listed on the income statement as either the gross revenue amount or net revenue. Net revenue includes all deductions for the return of goods, the possibility of undeliverable merchandise and the expense for unrecoverable accounts receivables (also known as “bad debt expense”, which flows into the balance sheet as the allowance for doubtful accounts). Gross revenue, on the other hand, does not include these deductions. The gross revenue presentation will have the deductions of Selling and Administration Expense including Depreciation Expense, Bad Debts/ Uncollectible Expense from gross revenue, and a subtotal for net revenue.

ABC company makes earnings before interest is BDT-950 in 2018, BDT 200 in 2017, BDT (250) Loss in 2016. Now Corporate Tax is another factor for less net profit. Here, investors should bear up in the mind Corporate Tax for specified invested sectors and Company Dividend Policy may affect.

The more corporate taxes, the less retained earning which may hit the company’s Dividend Policy. Different Company uses different depreciation methods. For the betterment of investors, we should analyze balance sheet/ financial position of the companies. From the balance sheet , we will see the scenario of Accounts Receivable.

Balance Sheet/ Statement of Financial Position Analysis
XYZ Company Ltd.

Analysis
As we can see in the comparative balance sheet above, the current assets of XYZ Co. have decreased by BDT. 35,200 in the year 2018 over 2017.

On the other hand, the current liabilities have decreased by BDT. 27,000 only. Now, such a change does not have a negative impact on the liquidity position of XYZ Co. This is because current assets have decreased by 33.9% whereas current liabilities have declined by 51.5%.

Secondly, the cash and bank balance of XYZ Co. have decreased by 91.5%. This indicates a negative cash position of the company. It further hints towards the fact that the company might find it challenging to meet its short-term obligations.

Next, the long-term debt of XYZ Co. has increased by 62.5%. On the other hand, the owner’s equity has improved by only 34%. This indicates that the company is way too dependent on the external lenders thus leading to a great financial risk for the firm.

Finally, there is a considerable increase seen in the fixed assets of the company. Accordingly, the fixed assets increased by BDT 79,000 or 64.9% from the year 2017 to 2018. This was on account of the huge addition made to the plant and machinery by the company in the given accounting periods.

Plant and machinery increased by BDT 95,200 that is by 153.5%. Such additional machinery leads to an incredible improvement in the production capacity of the company during the year. This expenditure was provided for by the company’s owners and the external lenders. We can analyze the data of XYZ Company one by one-

Cash and Bank Balance was 10.05% of total Assets in the year 2017, but it has been decreased to only 0.71% in 2018 which indicates Company has much liquidity crisis.

Debtors/ Account Receivable was 17.80% of total Assets in 2017 but it has decreased Account Receivable Collection to 13.54% which is good sign for the Company. But now the question is why the Company has liquidity crisis? Either the XYZ Company purchased Fixed Assets or there has a fraud forgery.

Inventory was 2.73% in 2017 but it was 0.92% in 2018 which is good sign for the company. Now we have to check either Inventory sold at Cash or on Credit but we saw it that Cash and Accounts Receivable has been decreased that was the cause of Short-Term Liability repaid or Fixed Assets purchased or fraud forgery to be checked. If we see that Plant and Machinery has increased by BDT 95,200 in 2018. On the other hand- Short-Term Liability has decreased by BDT 27,000 in 2018.

Land and Building was BTD. 54,000 in 2017 but it has declined to BDT. 34000 due to depreciation to be analyzed rationally as depreciation affects Net Income.

Plant and Machinery was BDT 65,000 in 2017 which has increased to BDT 1,57,200 in 2018 was purchased in Cash and on Credit through Long Term Debt and Own Capital of Shareholders. As Long-Term Debt has increased by BDT 25,000, Cash has decreased by BDT 21,600, Accounts Receivable has decreased by BDT 3,800 and Equity Share Increased by BDT 40,000.

Current ratio= Current Assets/ Current Liabilities
The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-term obligations that are due within a year.

Standard of Current Ratio is 2:1 which means to repay the BDT 1.00 of liabilities XYZ Co. should have BDT 2.00 Assets. Either the XYZ Co has more assets to invest/ increase production capacity or Accounts Receivable Collection Period is too bad. Now we have to analyze sales and sales collection.

Suppose, XYZ Company’s sales was BDT 1,40,000 in 2017 it was increased in BDT 1,85,000 in 2018. Sales was made 38 % in cash. We can calculate Accounts Receivable Turnover = Net Credit Sales/Average Accounts Receivable.

Here, in 2018 Collection Period is better than the year 2017. But Company’s collection too much bad which may surely affect Net Income due to more bad debt expense increase.

Profit margin on sales is good for the company. We have to analyze it through collection period and bad debts expense.

Asset Turnover measures how efficiently a company uses its assets to generate sales. Here, we have to analyze specific industries average.

An overall measure of profitability is return on assets. Quality’s return on assets improved from 2017 to 2018. Here, we also have to consider industry average.

Return on Common Stockholder’ Equity

It measures profitability from the common stockholders’ viewpoint. This ratio provides how many Taka of net income were earned for each Taka invested by the owners.

Earnings Per Share Formula Example
Suppose, PQ Ltd has a net income of BDT. 1.00 million in the third quarter. The company announces dividends of BDT. 250,000. Total shares outstanding is at 11,00,000.
EPS calculation Formula=(Net Income–Preferred Dividend)/ End of period Shares Outstanding
Or, EPS = (Net Income – Preferred Dividends) / Weighted Average Shares Outstanding
The EPS of PQ Ltd. would be: EPS = (1,000,000 – 250,000) / 11,00,000, EPS = BDT 0.68
Since every share receives an equal slice of the pie of net income, they would each receive BDT 0.68.

Price-Earning Ratio
=Market Price Per Share of Stock/ Earnings Per Share
Assume, market price of share of PQ Ltd was BDT. 10 & 12 respectively 2017 and 2018. You can find market price over DSE & CSE website of specified company.

Dividend Payout Ratio
=Cash Dividend/ Net Income
Assume that XYZ company paid cash dividend ( ignore stock dividend) was total BDT 9,000 in 2017 13,000 in 2018.

This ratio measures the percentage of earnings distributed in the form of cash dividends. The more growth rate companies generally pay out low ratios because they reinvest most of their net income into the business.

Analyst: Md. Badrul Millat Ibne Hannan, MPA AIS (DU), ACCA ( Final Level) and Officer, Islami Bank Bangladesh Limited