Master Class 6: Identifying the Bad Companies, Cash Flow Statement and Rights Issue

How to Identify Bad Stock!

One look at a company's financial statement can give a vague idea of its financial position. However, just one look at those figures cannot be enough to deduce the entire situation. One of the investors' common dilemmas is about how to identify if a company is bad or has bad stocks and is not a good option for investment.

This article will explain how to identify a bad company or bad stocks and discuss concepts like cash flow statement, rights issues, and how they influence our choice as a potential investor.

Identifying Bad Companies

The Profit & Loss Statement presents the income of the company. As the name suggests, it lists down all the expenses and incomes earned by the company in a financial year. It talks about net sales, operating expenses, interest paid, tax paid, and earned net income. The numbers of earnings are based on sales and not the payments the company receives.

For instance, you sell a product worth ₹100 to a customer. The customer tells you that he will make the payment at the end of the month, which is quite normal in the business world. Now, ₹100 will be added to the 'Net sales' in your 'Profit & Loss' statement, but the money for this has not been received yet. But what would happen if the customer never makes the payment? Suppose the customer is another company. What would happen if it shuts down? You would never be able to get your ₹100.

Investors might often make the mistake of investing in companies only by looking at its P/L statement, which looks strong. However, even if the Profit & Loss statement looks strong, can it receive all its payments? To clearly know about this company's scenario, one must refer to its 'Cash Flow Statement.'

Cash Flow Statement

A cash flow statement is a company's financial statement that shows the inflows and outflows of cash in the business, which is caused by its daily operations and as a result of any investment or financing done in the said accounting year.

One of the heads in the Cash Flow Statement is the 'Operating cash flow,' which explains the amount of money the company earned through its operating activities.

To get a clearer insight into a company's cash flows through its cash flow statement, one can add the values of the operating cash flow of the past five years. Now add the value of net profit to this value.

The more these two values (operating profits of 5 years and the total of operating profits of 5 years and net profit) are close, the better is the company's cash flow. This means that its liquidity is strong, and it is able to receive the money it shows as its profit.

A disparity in these two values of the cash flow statement reflects that the company is unable to get its money, and its distribution companies or buyers are not credible.

Have you read our previous Master Class: Asset Turnover, Cash Cycle Ratio and Share Split

The Rights Issue

This is an extension to the previous class on the rights issue. The rights issue is an offer to existing shareholders. With more shares coming in, if an investor keeps holding the same number of shares, their shareholding will dilute. Hence, the existing shareholders are given the first chance to buy more shares at less than the market price. This is known as the rights issue.

Let us understand how this affects an investor's earnings and why the rights issue is not favorable to existing investors despite the shares being available at a lower rate than the market price.

If a company brings a rights issue as 1:3, it means that for each share you own, you may buy 3 shares. Suppose the current market price of each share is ₹100. You are offered the rights issue at the rate of ₹50 per share. The deal looks alluring. You buy the 3 shares paying ₹150. Now let us see what happens.

Though the company took ₹150 from you, your earnings per share have fallen. Moreover, the market price of the shares changes based on the company's expected profit. In the rights issue, the company's profit would not change overnight, but the number of shares will do. Therefore, if the share price were ₹100 for one share, it would become ₹25 per share (because three new shares were created for one existing, hence four shares). Remember, you bought this rights issue for ₹50, thinking that the market price is ₹100, whereas, in reality, the market price is just ₹25 after the Issue.
What if you do not fall in the trap and do not buy this rights issue. Will you still be safe? No!

Suppose you pay ₹100 per share (at market price). Our EPS in the previous example was ₹10. It means that your investment of ₹100 fetches you ₹10 as earnings. This EPS falls after the rights issue. Ultimately, you would find yourself to have invested more money for the same EPS or lower earnings for the same amount of investment.

Let us understand it better.
Total earnings = EPS x Number of shares

Assume you had 50 shares before this 1:3 Rights Issue. You bought these 50 shares at the market price of ₹100. Hence, the total investment is ₹5000. The right Issue offers the shares at ₹50 per share. You buy 150 shares in this Issue. The new cost you pay is ₹50 x 150 shares = ₹7500. Hence, if you apply for the rights issue, your total investment becomes ₹12500. 

Let us judge the two scenarios. Earlier, you earned ₹500 against an investment of ₹5000. If you take the rights issue, you would earn ₹500 after an investment of ₹12500. If you choose not to apply, the earnings would fall to ₹125. In either scenario, you are not gaining much out of the rights issue. Hence, one should be wary of the companies offering rights issues frequently.

Conclusion

Identifying bad stocks can be a tricky thing to do. Both these concepts of Cash flows and Rights Issue can be confusing in the beginning. However, they hold quite a lot of relevance for every investor. Thus it becomes important for every investor always to do a thorough analysis of these values so that a bad investment decision into bad stocks can be avoided. You can also refer to this video tutorial, YouTube, to get a practical example from companies listed in the stock market.

Once an investor learns to identify companies with potentially bad stocks or seems like a risky investment, he/she can learn to identify the healthy opportunities and make such an informed decision that generates healthy returns for them. 

Check out the next blog series: Analysis of Banking stocks and the importance of CASA Ratio, NPA, CAR

To read all Master Class series Click Here