In the first part of this series, we figured out what the equity markets are and some important concepts. Now comes the harder question - Out of 5500+ listed companies, which ones should you even think about owning? Fundamental analysis provided a bunch of rules that will allow us to filter out few companies that clear the basic checks. At a very high level, your investing journey revolves around just two questions:
- What to buy/sell? → Quality of the business
- When to buy/sell? → Timing and price
What to buy?
When you do fundamental analysis, you are not trying to finesse a line going up and down on a chart. You are investing into a real business with real products, employees, and customers(and hopefully a long term vision).
What it is: Understanding the business, its financials, management, and industry to decide if the company is worth owning for long term.
What it uses:
- Annual reports and financial statements
- Balance sheet, P&L, cash flow analysis
- Financial ratios (Current Ratio, Debt/Equity, ROCE, P/E, P/B, EPS, etc.)
- Management quality assessment (are the people running it honest and competent?)
- Industry and economy trends (is the tide rising or falling for this sector?)
What it determines:
- Intrinsic value - The true worth of the business
- Is the company profitable and growing?
- Is management honest and capable?
- Does the business have competitive advantages?
- Is the story in presentations actually visible in the numbers?
When to use:
- Screening stocks - Finding quality companies worth investing in
- Finding undervalued gems - Identifying stocks trading below their true value
- Long-term investing - Building a portfolio for years
- Wealth creation - Compounding returns over time
Understanding Business Value
If you strip away all the jargon, fundamental analysis answers one simple question:
Will the company sustain 10 year from now? Will it remain profitable and growing?
To answer that, we look at two big pieces:
1. Quantitative Analysis (Number-driven)
- Economy Analysis - Is the overall economy growing?
- Industry Analysis - Is the sector doing well?
- Company Analysis - Are the company’s numbers strong?
2. Qualitative Analysis (Quality-driven)
- Management Analysis - Is the leadership honest and capable?
Think of a listed company as a person with three key documents:
- A list of what they own and owe → Balance Sheet
- Their salary slip → Profit & Loss (P&L) Statement
- Their bank statement → Cash Flow Statement
Annual reports pack all of this into a (usually boring) PDF. Once you know what to look for, it stops being boring and starts becoming a treasure hunt.
1. Balance Sheet Structure
The Balance Sheet Equation: Assets = Liabilities + Equity
Left Side - What the Company OWNS (Assets):
Non-Current Assets (Long-term, can’t convert to cash quickly)
- Fixed Assets: Land, buildings, machinery
- Intangible Assets: Patents, trademarks, goodwill
- Long-term Investments: Shares in other companies
Current Assets (Short-term, can convert to cash within a year)
- Inventories: Goods ready to sell
- Trade Receivables: Money customers owe you
- Cash & Cash Equivalents: Bank balance
- Short-term Investments: FDs, liquid funds
Right Side - What the Company OWES + OWNS (Liabilities + Equity):
Shareholder’s Funds (Owner’s money)
- Share Capital: Initial investment by shareholders
- Reserves & Surplus: Accumulated retained profits
Non-Current Liabilities (Long-term debt, payable after 1 year)
- Long-term loans, debentures, bonds
Current Liabilities (Short-term debt, payable within 1 year)
- Trade Payables: Money you owe suppliers
- Short-term loans and dues
Key Balance Sheet Terms:
If the company were a household:
- Assets = your house, car, gadgets, bank balance
- Liabilities = your home loan, credit card dues, personal loan
- Equity = what’s actually “yours” after paying off everything
Shareholder’s Funds (Equity) - Owners’ capital investment forming the foundation.
Reserves & Surplus - Retained profits reinvested rather than distributed, including:
- General Reserves
- Retained Earnings
- Securities Premium
Non-Current Liabilities - Debt payable beyond one year (debentures, long-term loans).
Critical Warning: If loan funds significantly exceed equity, extreme caution required. Historical disasters: Jet Airways, Suzlon, Reliance Communications.
2. Profit & Loss Statement
The P&L is just the company’s income-expense statement for the year. “How much came in, how much went out, and what was left.”
The P&L Waterfall (Example with ₹100 Crores revenue):
| Step | Description | Amount (₹ Cr) |
|---|---|---|
| Sales/Revenue | Total money earned | 100 |
| Less: Operating Costs | Raw materials, salaries, rent | -60 |
| = EBITDA | Operating profit before interest, tax, depreciation | 40 |
| Less: Depreciation & Amortization | Asset value reduction | -10 |
| = EBIT | Earnings before interest and tax | 30 |
| Less: Interest Expense | Loan interest payments | -10 |
| = PBT | Profit before tax | 20 |
| Less: Tax (30%) | Government’s share | -6 |
| = PAT (Net Profit) | Final profit shareholders get | 14 |
Key Terms Explained:
- EBITDA - Core business profitability (most important for operations)
- EBIT - Operating profit after accounting for asset depreciation
- PBT - Profit before paying taxes
- PAT - The bottom line - actual profit available to shareholders
When you look at a P&L over 5–10 years, you are basically asking:
- Are sales steadily going up?
- Is profit growing faster than sales?
- Are costs under control, or is the company forever blaming “input cost pressure”?
3. Cash Flow Statement Components
The cash flow statement is where you check “Kitna paisa actually aaya, kitna gaya?” Numbers on P&L can lie; cash is harder to fake for long.
Operating Activities - Cash from core business operations
- Negative = Core business burning cash (danger signal)
- Positive = Healthy operational cash generation
Investing Activities - Capital expenditure and asset sales
- Negative = More investments than divestments (often positive signal)
- Positive = Asset liquidation (context-dependent)
Financing Activities - Debt, equity, and dividend transactions (how money flows between company and lenders/shareholders)
- Negative = Debt repayment or dividend distribution
- Positive = Fresh borrowing or equity raising
Important Financial Ratios
This is the only slightly “math-looking” section. Don’t worry about memorising formulas. Focus on what the ratio is trying to tell you about the business. You can always look up the formula on Screener or Moneycontrol.
1. Current Ratio
Formula: Current Ratio = Current Assets ÷ Current Liabilities
What it measures: Can the company pay its short-term bills?
Personal life analogy: imagine you suddenly lose your job. Do you have enough in bank balance + liquid investments to comfortably survive the next few months of EMIs, rent, and bills? Current ratio asks the same question for a company.
Example Calculation:
| Item | Amount (₹ Cr) |
|---|---|
| Current Assets (cash, inventory, receivables) | 200 |
| Current Liabilities (short-term dues) | 100 |
| Current Ratio | 2.0 |
Interpretation Guide:
| Ratio | Status | Meaning |
|---|---|---|
| ≥ 2.0 | ✅ Excellent | ₹2 of assets for every ₹1 liability - Very healthy |
| 1.0-2.0 | ⚠️ Adequate | Can pay bills but monitor closely |
| < 1.0 | ❌ Danger | Not enough assets to pay liabilities - Red flag! |
Real-world example:
- Company has ₹200 Cr in current assets
- Owes ₹100 Cr in short-term liabilities
- Current Ratio = 200/100 = 2.0 ✅
- Interpretation: Company can comfortably pay all short-term dues
Why 2:1 is ideal: Provides safety buffer. Even if assets lose 50% value, company can still pay all bills.
2. Debt to Equity Ratio
Formula: Debt to Equity = Long-term Debt ÷ (Share Capital + Reserves)
What it measures: How much the company relies on borrowed money vs owner’s money
Think of this as the company’s EMI stress level. A little debt can accelerate growth (like a sensible home loan). Too much debt, and one bad year can take the whole business down.
Example Calculation:
| Component | Amount (₹ Cr) |
|---|---|
| Long-term Debt | 150 |
| Share Capital | 100 |
| Reserves & Surplus | 400 |
| Total Equity | 500 |
| Debt to Equity Ratio | 0.30 (or 0.3:1) |
Interpretation Guide:
| Ratio | Status | Meaning |
|---|---|---|
| 0 | ⭐ Best | Completely debt-free - No financial stress |
| < 1 | ✅ Good | Conservative - More equity than debt |
| 1-2 | ⚠️ Caution | Moderate leverage - Monitor carefully |
| > 2 | ❌ Danger | High risk - Debt is 2x the equity! |
Why it matters:
- High debt = High interest payments
- Economic slowdown → Can’t pay loans → Bankruptcy risk
- Remember: Jet Airways, Suzlon had debt/equity > 3!
Sector exceptions: Banks and NBFCs naturally have high debt (it’s their business model), so ignore this ratio for financial companies.
3. ROCE Ratio
Formula: ROCE = (EBIT ÷ Capital Employed) × 100
Capital Employed = Share Capital + Reserves + Long-term Debt
What it measures: How efficiently is the company using its capital to generate profits?
Imagine two shop owners in the same market:
- Shop A invested ₹10 lakh and earns ₹4 lakh/year
- Shop B invested ₹30 lakh and earns ₹5 lakh/year
Shop A has lower absolute profit but much higher ROCE. As a business owner, you would rather be Shop A.
Example Calculation:
| Component | Amount (₹ Cr) |
|---|---|
| EBIT (Operating Profit) | 300 |
| Share Capital | 200 |
| Reserves & Surplus | 800 |
| Long-term Debt | 500 |
| Capital Employed | 1,500 |
| ROCE | 20% |
Interpretation Guide:
| ROCE | Rating | Meaning |
|---|---|---|
| ≥ 20% | ⭐ Excellent | Every ₹100 invested generates ₹20+ profit |
| 15-20% | ✅ Good | Strong performance, competitive advantage |
| 10-15% | ⚠️ Average | Okay but nothing special |
| < 10% | ❌ Poor | Inefficient capital use - Look elsewhere |
Why it matters:
- Compares profit generation across different capital structures
- Higher ROCE = Better management efficiency
- Always compare with industry average and competitors
- Asian Paints has ROCE ~35%, cement companies ~15-18%
4. Free Cash Flow - Cash Generation Power
Formula: Free Cash Flow = Operating Cash Flow - Net Capital Expenditure
What it measures: Real cash left after running and maintaining the business
Example Calculation:
| Component | Amount (₹ Cr) |
|---|---|
| Operating Cash Flow | 500 |
| Capital Expenditure (purchases) | 350 |
| Sale of Assets | 50 |
| Net CapEx | 300 |
| Free Cash Flow | 200 ✅ |
Multi-Year Trend Analysis:
| Year | FCF (₹ Cr) | Status |
|---|---|---|
| 2020 | -100 | Negative |
| 2021 | -50 | Negative |
| 2022 | -80 | Negative ❌ |
| 2023 | 20 | Positive |
| 2024 | 150 | Positive |
Interpretation:
- 3+ consecutive negative years = ❌ DANGER - Business burning cash
- 1-2 negative years = ⚠️ CAUTION - Monitor closely
- Consistently positive = ✅ Healthy cash generation
Why FCF matters:
- Profit can be manipulated, but cash flow doesn’t lie
- Negative FCF = Company needs external funding to survive
- Positive FCF = Can pay dividends, reduce debt, or expand
- Growth companies may have negative FCF temporarily (expansion phase)
Very simplified thumb rule:
- Profits going up + cash flows also going up = Healthy
- Profits going up but cash flows constantly negative = Something smells off, dig deeper
5. Inventory Turnover Ratio
Formula: Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
What it measures: How many times inventory is sold and replaced in a year
Example Calculation:
| Component | Amount (₹ Cr) |
|---|---|
| Cost of Goods Sold (Annual) | 800 |
| Average Inventory | 100 |
| Inventory Turnover | 8 times/year |
| Days to Sell Inventory | 45 days |
What it means: The company sells and replaces its entire inventory 8 times in a year, or every 45 days.
Sector Benchmarks:
| Industry | Typical Turnover | Why? |
|---|---|---|
| FMCG | 12-20 times | Fast-moving, perishable goods |
| Retail | 8-12 times | Regular stock rotation |
| Automobile | 6-10 times | Moderate turnover |
| Heavy Equipment | 2-4 times | Slow-moving, expensive items |
Interpretation:
- Higher turnover = Goods sell quickly, less capital stuck
- Lower turnover = Inventory piling up, potential obsolescence risk
- Compare ONLY within same sector
- Increasing trend over years = ✅ Good
- Declining trend = ⚠️ Demand issues or poor management
For you as an investor, very low inventory turnover can mean future write-offs and margin pressure, especially in businesses where fashion and technology change quickly.
6. Reserves & Surplus Growth
What it measures: Is the company consistently retaining and growing profits year-over-year?
Formula: Track absolute reserves value over 5+ years
5-Year Trend Example:
| Year | Reserves (₹ Cr) | Year-on-Year Growth |
|---|---|---|
| 2020 | 1,000 | - |
| 2021 | 1,180 | +18% |
| 2022 | 1,350 | +14.4% |
| 2023 | 1,550 | +14.8% |
| 2024 | 1,780 | +14.8% |
| Average Growth | 15.5% ✅ |
Interpretation Guide:
| Average Growth | Status | Meaning |
|---|---|---|
| > 15% | ⭐ Excellent | Strong profit retention and reinvestment |
| 5-15% | ✅ Good | Steady growth, healthy business |
| 0-5% | ⚠️ Moderate | Slow growth, investigate why |
| Negative | ❌ Concern | Losses or excessive dividends |
Why it matters:
- Growing reserves = Company keeping profits for expansion
- Declining reserves = Warning sign - losses or cash distribution
- Consistent growth over 5+ years = Quality compounding business
- Compare trend, not absolute value
Red flag: If reserves decline while profit is positive, where’s the money going?
7. P/E Ratio
Formula: P/E Ratio = Market Price per Share ÷ Earnings Per Share (EPS)
What it measures: How much you’re paying for each rupee of company earnings
Example Calculation:
| Component | Value |
|---|---|
| Market Price per Share | ₹1,500 |
| Earnings Per Share (EPS) | ₹100 |
| P/E Ratio | 15 |
What it means: You’re paying ₹15 for every ₹1 of annual earnings
Comparative Analysis (Example: IT Sector):
| Company | P/E | Industry Avg | Verdict |
|---|---|---|---|
| Company A | 15 | 22 | Cheaper than industry |
| Company B | 28 | 22 | Expensive vs industry |
| Company C | 12 | 22 | Very cheap - WHY? |
CRITICAL: Always Compare with Industry, Not Absolute Numbers
Interpretation Framework:
Scenario 1: Low P/E + Strong Fundamentals (all 7 ratios good)
- Verdict: ✅ OPPORTUNITY - Undervalued gem
Scenario 2: Low P/E + Weak Fundamentals (poor ratios)
- Verdict: ❌ VALUE TRAP - Cheap for a reason
Scenario 3: High P/E + Strong Fundamentals
- Verdict: ⚠️ Fairly valued or expensive - Market expects growth
Why P/E is the LAST ratio to check:
- First verify business quality (ratios 1-6)
- Then check if price is reasonable (P/E)
- Low P/E alone means NOTHING without context
8. EPS Ratio
Formula: EPS = Profit After Tax (PAT) ÷ Total Outstanding Shares
What it measures: Company’s profit allocated to each share
Example Calculation:
| Component | Value |
|---|---|
| Profit After Tax (PAT) | ₹1,400 Cr |
| Total Outstanding Shares | 140 Cr shares |
| EPS | ₹10 per share |
5-Year EPS Growth Tracking:
| Year | EPS (₹) | Growth % |
|---|---|---|
| 2020 | 50 | - |
| 2021 | 58 | +16% |
| 2022 | 65 | +12% |
| 2023 | 75 | +15% |
| 2024 | 87 | +16% |
| CAGR | 14.8% ✅ |
Interpretation Guide:
| EPS Trend | Status | Meaning |
|---|---|---|
| Consistently growing | ⭐ Excellent | Quality business, increasing profits |
| Stable/flat | ⚠️ Moderate | No growth, mature business |
| Declining | ❌ Red Flag | Falling profitability |
| Volatile | ⚠️ Caution | Inconsistent, risky business |
Why EPS matters:
- Direct indicator of per-share profitability
- Growing EPS → Stock price usually follows up
- Declining EPS → Even if cheap, avoid!
- Check 5-year trend, not just one year
Watch out for: EPS can increase artificially through share buybacks (reducing denominator). Check if PAT is also growing!
Stock Valuation: EV/EBITDA Method
Enterprise Value to EBITDA is a popular valuation method used to calculate fair value of stocks.
Step-by-Step Valuation Process:
Step 1: Gather Historical Data (Go to MoneyControl → Ratios → Valuation)
| Year | EV (₹ Cr) | EV/EBITDA | EBITDA (Calc) | Growth % |
|---|---|---|---|---|
| 2020 | 50,000 | 18.5 | 2,703 | - |
| 2021 | 58,000 | 19.2 | 3,021 | +11.8% |
| 2022 | 65,000 | 18.8 | 3,457 | +14.4% |
| 2023 | 72,000 | 19.0 | 3,789 | +9.6% |
| 2024 | 80,000 | 18.5 | 4,324 | +14.1% |
Step 2: Calculate EBITDA for each year
- Formula: EBITDA = EV ÷ EV/EBITDA ratio
- Example 2024: 80,000 ÷ 18.5 = 4,324
Step 3: Determine Average EBITDA Growth
- Average of growth rates = (11.8 + 14.4 + 9.6 + 14.1) ÷ 4 = 12.5% average growth
Step 4: Forecast Next Year EBITDA
- Expected EBITDA (2025) = 4,324 × (1 + 0.125) = 4,865 Cr
Step 5: Calculate Forecasted Enterprise Value
- Forecasted EV = Expected EBITDA × Current EV/EBITDA
- Forecasted EV = 4,865 × 18.5 = 90,000 Cr
Step 6: Adjust for Debt to Get Equity Value
- Equity Value = Forecasted EV - Total Debt
- Equity Value = 90,000 - 15,000 = 75,000 Cr
Step 7: Calculate Target Price
- Target Price = Equity Value ÷ Outstanding Shares
- Target Price = 75,000 Cr ÷ 10 Cr shares = ₹750 per share
Step 8: Entry Price with Margin of Safety (30% discount)
- Recommended Entry = Target Price × 0.70
- Recommended Entry = 750 × 0.70 = ₹525
Final Verdict:
- Target Price: ₹750
- Buy if below: ₹525 (30% margin of safety)
- Current Price: ₹600 → BUY (below ₹750, room for upside)
Sector-Specific Analysis
Different industries require tailored analytical approaches:
Banks & NBFCs
Standard ratios DON’T apply to banks - Don’t check Debt:Equity ratio or operating cash flows. Instead focus on:
Banking-Specific Metrics:
1. CASA Ratio (Current Account + Savings Account)
| Metric | Formula | Good Value | Why It Matters |
|---|---|---|---|
| CASA Ratio | (CA + SA) ÷ Total Deposits × 100 | > 40% | Low-cost deposits = Higher profit margins |
Example: HDFC Bank CASA ~45% (Excellent), Small bank CASA ~25% (Poor)
2. NIM (Net Interest Margin)
| Metric | Formula | Good Value | Meaning |
|---|---|---|---|
| NIM | (Interest Income - Interest Expense) ÷ Earning Assets × 100 | > 3% | Spread between lending and borrowing rates |
Higher NIM = Bank earns more on each rupee lent
3. NPA Ratio (Non-Performing Assets)
| NPA Level | Ratio | Status | Action |
|---|---|---|---|
| Excellent | < 2% | ✅ | Strong asset quality |
| Acceptable | 2-3% | ⚠️ | Monitor trend |
| Poor | 3-5% | ❌ | High risk |
| Dangerous | > 5% | 🚫 | Avoid |
NPA = Loans not being repaid → Lower profits → Avoid banks with rising NPAs
FMCG Companies
Focus on inventory turnover - fast-moving goods should have high turnover ratios (8x+ annually).
Telecom Sector
Key Metric: ARPU (Average Revenue Per User)
Formula: ARPU = Total Revenue ÷ Total Subscribers
Example Calculation:
| Metric | Value |
|---|---|
| Monthly Revenue | ₹10,000 Crores |
| Active Subscribers | 35 Crore users |
| ARPU | ₹286/month/user |
Why ARPU Matters:
- Rising ARPU = Company increasing prices OR customers using more services
- Falling ARPU = Price war OR customers downgrading plans
- Compare quarter-over-quarter trends
Real Example:
- Jio ARPU: ₹175/month (rising trend = good)
- Airtel ARPU: ₹200/month (rising trend = excellent)
Infrastructure Companies
Key Metric: Order Book Analysis
Order book = Confirmed future projects/orders yet to be executed
Formula: Order Book to Revenue Ratio = Current Order Book ÷ Annual Revenue
Example:
| Metric | Amount (₹ Cr) |
|---|---|
| Current Order Book | 60,000 |
| Annual Revenue | 20,000 |
| Ratio | 3.0 |
Interpretation:
| Ratio | Status | Meaning |
|---|---|---|
| ≥ 3 | ⭐ Excellent | 3+ years of revenue visibility |
| 2-3 | ✅ Good | 2-3 years secured orders |
| 1-2 | ⚠️ Moderate | Limited visibility, needs new orders |
| < 1 | ❌ Poor | Less than 1 year work, risky |
Why it matters:
- Infrastructure projects take years to complete
- Higher order book = Predictable future revenue
- L&T typically maintains 2.5-3x order book
Industry & Economy Analysis
Economic Indicators Impact
GDP Growth - Aggregate economic output affecting overall market sentiment.
Repo Rate - RBI’s lending rate to banks influencing borrowing costs.
The Domino Effect of Repo Rate Increase:
- RBI increases Repo Rate (e.g., from 6% to 6.5%) ↓
- Banks increase lending rates (home loans, business loans become expensive) ↓
- Companies borrow less (expansion plans delayed) ↓
- Production decreases (less capacity addition) ↓
- GDP growth slows (economy cools down) ↓
- Stock market falls (negative sentiment)
Impact: Repo rate hike = Generally negative for stock markets Exception: Banking stocks may benefit (higher lending margins)
CRR (Cash Reserve Ratio) - Percentage of deposits banks must maintain with RBI.
SLR (Statutory Liquidity Ratio) - Percentage banks must keep in liquid assets.
Monetary Policy Impact on Markets:
| Factors Tightening | Impact Level | Market Sentiment | Action |
|---|---|---|---|
| 2-3 factors (CRR + SLR + Repo) | Strong | ❌ Negative | Be cautious, book profits |
| 1 factor | Moderate | ⚠️ Neutral | Sector-specific impact |
| 0 factors (cuts instead) | Accommodative | ✅ Positive | Good time to invest |
Balance of Payments (BoP)
Formula: BoP = Exports - Imports
Scenario Analysis:
Surplus BoP (Exports > Imports):
- Status: ✅ Trade Surplus
- Forex Impact: Rising foreign currency reserves
- Currency: Rupee strengthens
- Market Sentiment: Bullish for equity markets
- Example: India exports $50B, imports $45B → $5B surplus
Deficit BoP (Imports > Exports):
- Status: ❌ Trade Deficit
- Forex Impact: Depleting reserves
- Currency: Rupee weakens
- Market Sentiment: Cautious, potential FII outflows
- Example: India exports $40B, imports $55B → $15B deficit
Why it matters: Sustained deficits lead to rupee depreciation → Higher inflation → RBI forced to raise rates → Negative for markets
Cyclical Industries
Industries performing strongly during economic booms but struggling in recessions:
- Automobiles
- Real Estate
- Infrastructure
- Consumer Durables
Investment Strategy: Buy during recession lows, sell during boom peaks.
Management Quality Assessment
Quantitative metrics alone insufficient - qualitative management analysis critical:
Due Diligence Checklist:
1. Background Verification
- Google search: ”[Company Name] + fraud” or ”+ scam” or ”+ cases”
- Check LinkedIn profiles of CEO, CFO, MD
- Verify educational credentials and past experience
- Research track record at previous companies
- Any past failures or regulatory issues?
2. Annual Report Deep Dive
- Read Management Discussion & Analysis (MD&A) section
- Understand future projects and strategic vision
- Check for penalties and regulatory actions disclosed
- Scrutinize Related Party Transactions (RPTs)
- High RPTs = Red flag (promoters doing self-dealing)
3. Auditor’s Report (First 3 pages of Annual Report)
- Look for phrase “True and Fair View” = Clean report
- Read Key Audit Matters (KAM) - Areas of concern
- Check for “Going Concern” issues
- Any Qualified Opinion = Major red flag, avoid!
4. Shareholding Pattern
- Promoter holding trends:
- Increasing = Good (confidence in business)
- Decreasing = Warning (promoters exiting?)
- Pledged shares:
- < 10% = Acceptable
- 20-50% = Caution
50% = Danger (promoters need cash badly)
- Check for insider trading charges
- Monitor bulk deals by promoters (selling or buying?)
5. Investor Communications
- Read quarterly earnings call transcripts
- How does management respond to tough questions?
- Do they provide clear guidance or dodge questions?
- Compare past promises vs actual delivery
Management Red Flags Checklist:
| Red Flag | Threshold | Severity | What It Means |
|---|---|---|---|
| Promoter selling heavily | > 5% reduction/year | 🚩 High | Loss of confidence in business |
| High pledged shares | > 50% pledged | 🚩 High | Desperate for cash, bankruptcy risk |
| Frequent auditor changes | > 1 change in 5 years | 🚩 Medium | Trying to hide something? |
| Qualified audit opinion | Any qualification | 🚩 Critical | AVOID immediately! |
| Insider trading cases | Any cases | 🚩 High | Unethical management |
| High Related Party Transactions | > 20% of revenue | 🚩 Medium | Self-dealing, siphoning money |
| Excessive mgmt compensation | > 10% of profits | 🚩 Medium | Enriching themselves |
Decision Matrix:
| Red Flags Count | Verdict | Action |
|---|---|---|
| 3 or more | ❌ AVOID | Don’t invest, too risky |
| 1-2 flags | ⚠️ INVESTIGATE | Dig deeper, understand context |
| 0 flags | ✅ CLEAN | Green signal for management quality |
Real Examples:
- Yes Bank: Multiple red flags ignored → Collapsed
- Satyam: Qualified audit opinion → Massive fraud
- Jet Airways: High debt + pledged shares → Bankruptcy
Consolidated vs Standalone Financials
Standalone Financial Statements - Parent company only (head office + domestic/international branches)
Consolidated Financial Statements - Includes:
- Parent company
- Subsidiary companies (>50% ownership)
- Associate companies (20-50% ownership)
- Joint ventures
Analysis Tip: Always analyze consolidated statements for complete business picture, especially for holding companies with significant subsidiaries.