Reading a company's numbers

A full set of financial statements runs to hundreds of pages. Almost none of it matters for what a derivatives trader needs to know, which is a single question:

How likely is this company to produce a nasty surprise?

That question can be answered from about eight numbers.

The three statements, in one line each#

Profit and loss — what the company earned and spent over a period. Revenue at the top, profit at the bottom.

Balance sheet — what it owns and owes at a point in time. Assets on one side, liabilities and equity on the other.

Cash flow — cash actually moving in and out. The one that is hardest to dress up.

Beginners read the P&L, glance at the balance sheet, and skip cash flow. That is exactly backwards from a risk perspective.

Start with cash flow#

Profit is an opinion. Cash is a fact.

Profit involves judgement calls: when to recognise revenue, how fast to depreciate, what to provision for. All legitimate, all discretionary, all capable of making a bad quarter look acceptable.

Cash is harder to manufacture. Either it arrived or it did not.

The line to look at is cash flow from operations. It should be positive, and it should bear a sensible relationship to reported profit over time.

Then debt#

Debt is not bad in itself. Unmanageable debt is.

Two numbers tell you most of it:

Debt to equity. How much is borrowed against what the owners have put in. What counts as high varies enormously by sector — infrastructure and finance run leverage that would be alarming in software — so compare within a sector, never across.

Interest coverage. Operating profit divided by interest expense. This says whether the company comfortably covers its interest bill. A ratio near or below 1 means interest is consuming everything the business earns, and the company is one bad quarter from difficulty.

Interest coverage is the more useful of the two for spotting fragility, because it measures whether the debt is actually serviceable rather than just how much of it there is.

Then promoter pledging#

This one is specific to Indian markets and matters more for a trader than almost anything else on the list.

Promoters — the founding or controlling shareholders — sometimes pledge their shares as collateral for personal or company loans. If the share price falls far enough, the lender can sell those shares.

That creates a feedback loop that is genuinely dangerous: price falls, pledged shares get sold, selling pushes price lower, more shares get sold.

High pledging is one of the strongest predictors of the sudden, severe, multi-day declines that destroy option sellers and gap through stops. It is disclosed in the shareholding pattern, and it takes thirty seconds to check.

Then revenue quality#

Two questions:

Is revenue growing, and how? Growth from selling more is durable. Growth from a one-off asset sale is not. "Other income" propping up an otherwise flat business is worth noticing.

Is it concentrated? A company earning most of its revenue from one customer or one geography carries a risk that does not appear anywhere in the ratios. Losing that customer is a step change, not a trend.

What to ignore#

For short-term trading purposes:

• Precise valuation multiples. P/E ratios are useful for investors and nearly useless for timing. Cheap stocks fall; expensive ones rise.
• Management commentary. It is universally optimistic. Read the numbers instead.
• Most ratios. There are dozens. They largely restate the same handful of facts.
• Analyst targets. Broadly uncorrelated with what happens next.

The checklist#

Before trading a stock derivative:

Five checks, a few minutes, and you have answered the only fundamental question a short-term trader needs: is the ground under this thing solid?

Check yourself

0 of 4 answered

1. 1.A company reports rising profits for four consecutive quarters while operating cash flow stays negative. What does this most likely indicate?

   Strong growth requiring reinvestment — a healthy signProfit may be booked on uncollected sales or deferred costs, which tends to correct suddenlyThe company is paying down debt aggressivelyNothing unusual; cash flow and profit are unrelated

2. 2.Why does promoter pledging matter so much to a derivatives trader specifically?

   Pledged shares cannot be traded in F&OIt signals that promoters are optimistic about the stockFalling prices can trigger forced sales of pledged shares, creating a self-reinforcing declineIt affects the dividend payout ratio

3. 3.An interest coverage ratio close to 1 means:

   The company has no debtOperating profit barely covers the interest bill, leaving no margin for a bad quarterDebt equals equityThe company is paying an interest rate of 1%

4. 4.Which of these is least useful for deciding whether to hold a leveraged position for a few days?

   The next earnings dateOperating cash flow relative to profitThe price-to-earnings multiplePromoter pledging levels

What to take away

• Cash flow first. Profit is an opinion; cash is a fact.
• Profit rising while operating cash flow lags is the strongest accessible red flag.
• Interest coverage beats debt-to-equity for spotting fragility.
• Promoter pledging creates forced-selling feedback loops — check it every time.
• Ignore valuation multiples, management commentary and analyst targets for short-term trading.
• You are screening for fragility, not valuing a business.