fundamental analysis of balance sheet

7/25/2019 Fundamental Analysis of Balance Sheet

1/26

Fundamental Analysis: Introduction

So, you want be a stock analyst? Perhaps not, but since you're reading this we'llassume that you at least want to understand stocks. Whether it's your burning desire to

be a hotshot analyst on Wall Street or you just like to be hands-on with your ownportfolio, you'e come to the right spot.

!undamental analysis is the cornerstone of inesting. "n fact, some would say that youaren't really inesting if you aren't performing fundamental analysis.#ecause thesubject is so broad, howeer, it's tough to know where to start. $here are an endlessnumber of inestment strategies that are ery different from each other, yet almost alluse the fundamentals.

$he goal of this tutorial is to proide a foundation for understanding fundamental

analysis. "t's geared primarily at new inestors who don't know abalance sheetfromanincome statement.While you may not be a %stock-picker e&traordinaire% by the endof this tutorial, you will hae a much more solid grasp of the language and concepts

behind security analysis and be able to use this to further your knowledge in otherareas without feeling totally lost.

$he biggest part of fundamental analysis inoles deling into the financialstatements. lso known as (uantitatie analysis, this inoles looking at reenue,e&penses, assets, liabilitiesand all the other financial aspects of a company.!undamental analysts look at this information to gain insight on a company's future

performance. good part of this tutorial will be spent learning about the balancesheet, income statement, cash flow statementand how they all fit together.

#ut there is more than just number crunching when it comes to analy)ing a company.$his is where (ualitatie analysis comes in - the breakdown of all the intangible,difficult-to-measure aspects of a company. !inally, we'll wrap up the tutorial with anintro on aluation and point you in the direction of additional tutorials you might beinterested in.

*lso, although it's not re(uired, you might find it helpful to read ourInvesting 101tutorial, as well as our tutorial on Stock Basics,before starting.+

eady? et's die into things with our first section, What Is It?

Fundamental Analysis: What Is It?

"n this section we are going to reiew the basics of fundamental analysis, e&amine

how it can be broken down into (uantitatieand (ualitatiefactors, introduce the

subject of intrinsic alueand conclude with some of the downfalls of using thistechni(ue.
http://www.investopedia.com/terms/a/analyst.asphttp://www.investopedia.com/terms/p/portfolio.asphttp://www.investopedia.com/terms/b/balancesheet.asphttp://www.investopedia.com/terms/i/incomestatement.asphttp://www.investopedia.com/terms/i/incomestatement.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/e/expense.asphttp://www.investopedia.com/terms/a/asset.asphttp://www.investopedia.com/terms/l/liability.asphttp://www.investopedia.com/terms/c/cashflow.asphttp://www.investopedia.com/terms/c/cashflow.asphttp://www.investopedia.com/university/beginner/http://www.investopedia.com/university/stocks/http://www.investopedia.com/terms/q/quantitativeanalysis.asphttp://www.investopedia.com/terms/q/quantitativeanalysis.asphttp://www.investopedia.com/terms/q/qualitativeanalysis.asphttp://www.investopedia.com/terms/i/intrinsicvalue.asphttp://www.investopedia.com/terms/i/intrinsicvalue.asphttp://www.investopedia.com/terms/p/portfolio.asphttp://www.investopedia.com/terms/b/balancesheet.asphttp://www.investopedia.com/terms/i/incomestatement.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/e/expense.asphttp://www.investopedia.com/terms/a/asset.asphttp://www.investopedia.com/terms/l/liability.asphttp://www.investopedia.com/terms/c/cashflow.asphttp://www.investopedia.com/university/beginner/http://www.investopedia.com/university/stocks/http://www.investopedia.com/terms/q/quantitativeanalysis.asphttp://www.investopedia.com/terms/q/qualitativeanalysis.asphttp://www.investopedia.com/terms/i/intrinsicvalue.asphttp://www.investopedia.com/terms/a/analyst.asp


2/26

$he ery #asics

When talking about stocks, fundamental analysis is a techni(ue that attempts to

determine a security's alue by focusing on underlying factors that affect a company's

actualbusiness and its future prospects. /n a broader scope, you can perform

fundamental analysis on industriesor the economyas a whole. $he term simply refersto the analysis of the economic well-being of a financial entity as opposed to only its

price moements.

!undamental analysis seres to answer (uestions, such as0

"s the company's reenue growing?

"s it actually making aprofit?

"s it in a strong-enough position to beat out its competitors in the future?

"s it able to repay its debts?

"s management trying to %cook the books%?

/f course, these are ery inoled (uestions, and there are literally hundreds of others

you might hae about a company. "t all really boils down to one (uestion0 "s the

company's stock a good inestment? $hink of fundamental analysis as a toolbo& to

help you answer this (uestion.

1ote0 $he term fundamental analysis is used most often in the conte&t of stocks, but

you can perform fundamental analysis on any security, from a bond to a deriatie. s

long as you look at the economic fundamentals, you are doing fundamental analysis.

!or the purpose of this tutorial, fundamental analysis always is referred to in the

conte&t of stocks.

Fundamentals: Quantitative and Qualitative2ou could define fundamental analysis as %researching the fundamentals%, but that

doesn't tell you a whole lot unless you know what fundamentals are. s we mentioned

in the introduction, the big problem with defining fundamentals is that it can include

anything related to the economic well-being of a company. /bious items include

things like reenue and profit, but fundamentals also include eerything from a

company's market share to the (uality of its management.

$he arious fundamental factors can be grouped into two categories0 (uantitatie and
http://www.investopedia.com/terms/i/industry.asphttp://www.investopedia.com/terms/e/economy.asphttp://www.investopedia.com/terms/e/economy.asphttp://www.investopedia.com/terms/p/profit.asphttp://www.investopedia.com/terms/d/debt.asphttp://www.investopedia.com/terms/c/cookthebooks.asphttp://www.investopedia.com/terms/i/industry.asphttp://www.investopedia.com/terms/e/economy.asphttp://www.investopedia.com/terms/p/profit.asphttp://www.investopedia.com/terms/d/debt.asphttp://www.investopedia.com/terms/c/cookthebooks.asp


3/26

(ualitatie. $he financial meaning of these terms isn't all that different from their

regular definitions. 3ere is how the 4S1 5ncarta dictionary defines the terms0

6uantitatie 7 capable of being measured or e&pressed in numerical terms.

6ualitatie 7 related to or based on the (uality or character of something, often

as opposed to its si)e or (uantity.

"n our conte&t, (uantitatie fundamentals are numeric, measurable characteristics

about a business. "t's easy to see how the biggest source of (uantitatie data is the

financial statements. 2ou can measure reenue, profit, assets and more with great

precision.

$urning to (ualitatie fundamentals, these are the less tangible factors surrounding a

business - things such as the (uality of a company's board members and keye&ecuties, its brand-name recognition,patentsorproprietary technology.

Quantitative Meets Qualitative

1either (ualitatie nor (uantitatie analysis is inherently better than the other. "nstead,

many analysts consider (ualitatie factors in conjunction with the hard, (uantitatie

factors. $ake the 8oca-8ola 8ompany, for e&ample. When e&amining its stock, an

analyst might look at the stock's annual diidend payout, earnings per share, P95 ratio

and many other (uantitatie factors. 3oweer, no analysis of 8oca-8ola would be

complete without taking into account its brand recognition. nybody can start acompany that sells sugar and water, but few companies on earth are recogni)ed by

billions of people. "t's tough to put your finger on e&actly what the 8oke brand is

worth, but you can be sure that it's an essential ingredient contributing to the

company's ongoing success.

The Concept of Intrinsic Value

#efore we get any further, we hae to address the subject of intrinsic alue. /ne of the

primary assumptions of fundamental analysis is that the price on the stock market

does not fully reflect a stock's %real% alue. fter all, why would you be doing price

analysis if the stock market were always correct? "n financial jargon, this true alue is

known as the intrinsic alue.

!or e&ample, let's say that a company's stock was trading at :;


4/26

$his leads us to one of the second major assumptions of fundamental analysis0 in the

long run, the stock market will reflect the fundamentals. $here is no point in buying a

stock based on intrinsic alue if the price neer reflected that alue. 1obody knows

how long %the long run% really is. "t could be days or years.

$his is what fundamental analysis is all about. #y focusing on a particular business, an

inestor can estimate the intrinsic alue of a firm and thus find opportunities where he

or she can buy at a discount. "f all goes well, the inestment will pay off oer time as

the market catches up to the fundamentals.

$he big unknowns are0

>+2ou don't know if your estimate of intrinsic alue is correct and

;+2ou don't know how long it will take for the intrinsic alue to be reflected in the

marketplace.

Criticisms of Fundamental Analysis

$he biggest criticisms of fundamental analysis come primarily from two groups0

proponents of technical analysisand belieers of the %efficient market hypothesis%.

$echnical analysis is the other major form of security analysis. We're not going to get

into too much detail on the subject. *4ore information is aailable in ourIntroduction

to Technical Analysistutorial.+

Put simply, technical analysts base their inestments *or, more precisely, their trades+

solely on the price and olume moements of securities. @sing charts and a number of

other tools, they trade on momentum, not caring about the fundamentals. While it is

possible to use both techni(ues in combination, one of the basic tenets of technical

analysis is that the market discounts eerything. ccordingly, all news about a

company already is priced into a stock, and therefore a stock's price moements giemore insight than the underlying fundamental factors of the business itself.

!ollowers of the efficient market hypothesis, howeer, are usually in disagreement

with both fundamental and technical analysts. $he efficient market hypothesis

contends that it is essentially impossible to produce market-beating returns in the long

run, through either fundamental or technical analysis. $he rationale for this argument

is that, since the market efficiently prices all stocks on an ongoing basis, any

opportunities for e&cess returns deried from fundamental *or technical+ analysis

would be almost immediately whittled away by the market's many participants,
http://www.investopedia.com/terms/t/technicalanalysis.asphttp://www.investopedia.com/terms/e/efficientmarkethypothesis.asphttp://www.investopedia.com/university/technical/http://www.investopedia.com/university/technical/http://www.investopedia.com/university/technical/http://www.investopedia.com/terms/t/technicalanalysis.asphttp://www.investopedia.com/terms/e/efficientmarkethypothesis.asphttp://www.investopedia.com/university/technical/http://www.investopedia.com/university/technical/


5/26

making it impossible for anyone to meaningfully outperform the market oer the long

term.

Fundamental Analysis: Qualitative Factors - The Company

#efore diing into a company's financial statements, we're going to take a look atsome of the (ualitatieaspects of a company.

!undamental analysis seeks to determine the intrinsic alue of a company's stock. #utsince (ualitatie factors, by definition, represent aspects of a company's business thatare difficult or impossible to (uantify, incorporating that kind of information into a

pricing ealuation can be (uite difficult. /n the flip side, as we'e demonstrated, youcan't ignore the less tangible characteristics of a company.

"n this section we are going to highlight some of the company-specific (ualitatiefactors that you should be aware of.

Business Model5en before an inestor looks at a company's financial statements or does anyresearch, one of the most important (uestions that should be asked is0 What e&actlydoes the company do? $his is referred to as a company's business model 7 it's how acompany makes money. 2ou can get a good oeriew of a company'sbusiness model

by checking out its website or reading the first part of its >


6/26

inesting in this area. Similarly, unless you understand a company's business model,you don't know what the driers are for future growth, and you leae yourselfulnerable to being blindsided like shareholders of #oston 8hicken were.

Competitive Advantage

nother business consideration for inestors is competitie adantage. company'slong-term success is drien largely by its ability to maintain a competitie adantage -and keep it. Powerful competitie adantages, such as 8oca 8ola's brand name and4icrosoft's domination of the personal computer operating system, create a moataround a business allowing it to keep competitors at bay and enjoy growth and profits.When a company can achiee competitie adantage, its shareholders can be wellrewarded for decades.

3arard #usinessSchool professor 4ichaelPorter, distinguishes between strategic

positioning and operational effectieness./perational effectieness means a company is

better than rials at similar actiities whilecompetitie adantage means a company is

performing better than rials by doing differentactiities or performing similar actiities indifferent ways. "nestors should know that few

companies are able to compete successfully forlong if they are doing the same things as theircompetitors.Professor Porter argues that, in general,sustainable competitie adantage gained by0

uni(ue competitie position

8lear tradeoffs and choices is-E-is

competitors

ctiities tailored to the companyF's

strategy

high degree of fit across actiities *it is

the actiity system, not the parts, thatensure sustainability+

high degree of operational effectieness
http://www.investopedia.com/terms/e/economicmoat.asphttp://www.people.hbs.edu/mporter/bio.htmlhttp://www.people.hbs.edu/mporter/bio.htmlhttp://www.investopedia.com/terms/e/economicmoat.asphttp://www.people.hbs.edu/mporter/bio.htmlhttp://www.people.hbs.edu/mporter/bio.html


7/26

Management

Gust as an army needs a general to lead it to ictory, a company relies uponmanagement to steer it towards financial success. Some beliee that management isthemost important aspect for inesting in a company. "t makes sense - een the best

business model is doomed if the leaders of the company fail to properly e&ecute theplan.

So how does an aerage inestor go about ealuating the management of a company?

$his is one of the areas in which indiiduals are truly at a disadantage compared toprofessional inestors. 2ou can't set up a meeting with management if you want toinest a few thousand dollars. /n the other hand, if you are a fund manager interestedin inesting millions of dollars, there is a good chance you can schedule a face-to-facemeeting with the upper brass of the firm.

5erypublic companyhas a corporate information section on its website. @suallythere will be a (uick biography on each e&ecutie with their employment history,educational background and any applicable achieements. Bon't e&pect to findanything useful here. et's be honest0 We're looking for dirt, and no company is goingto put negatie information on its corporate website.

"nstead, here are a few ways for you to get a feel for management0

>. Conference Calls$he 8hief 5&ecutie /fficer*85/+ and 8hief !inancial /fficer*8!/+ host (uarterlyconference calls. *Sometimes you'll get other e&ecuties as well.+ $he first portion ofthe call is management basically reading off the financial results. What is reallyinteresting is the (uestion-and-answer portion of the call. $his is when the line is openfor analysts to call in and ask management direct (uestions. nswers here can bereealing about the company, but more importantly, listen for candor. Bo they aoid(uestions, like politicians, or do they proide forthright answers?

;.Manageent !iscussion and Analysis "M!#A$$he 4anagement Biscussion and nalysisis found at the beginning of the annualreport *discussed in more detail later in this tutorial+. "n theory, the 4BH issupposed to be frank commentary on the management's outlook. Sometimes thecontent is worthwhile, other times it'sboilerplate. /ne tip is to compare whatmanagement said in past years with what they are saying now. "s it the same materialrehashed? 3ae strategies actually been implemented? "f possible, sit down and readthe last fie years of 4BHs it can be illuminating.

I. %&nershi' and Insider SalesGust about any large company will compensate e&ecuties with a combination of cash,

restricted stock and options. While there are problems with stock options *See(uttingManageent )nder the Microsco'e+, it is a positie sign that members of
http://www.investopedia.com/terms/p/publiccompany.asphttp://www.investopedia.com/terms/c/ceo.asphttp://www.investopedia.com/terms/c/cfo.asphttp://www.investopedia.com/terms/m/mdanalysis.asphttp://www.investopedia.com/terms/b/boilerplate.asphttp://www.investopedia.com/terms/o/option.asphttp://www.investopedia.com/articles/stocks/05/050205.asphttp://www.investopedia.com/articles/stocks/05/050205.asphttp://www.investopedia.com/terms/p/publiccompany.asphttp://www.investopedia.com/terms/c/ceo.asphttp://www.investopedia.com/terms/c/cfo.asphttp://www.investopedia.com/terms/m/mdanalysis.asphttp://www.investopedia.com/terms/b/boilerplate.asphttp://www.investopedia.com/terms/o/option.asphttp://www.investopedia.com/articles/stocks/05/050205.asphttp://www.investopedia.com/articles/stocks/05/050205.asp


8/26

management are also shareholders. $he ideal situation is when the founder of thecompany is still in charge. 5&amples include #ill Jates *in the 'K


9/26

$his aspect of corporate goernance e&amines the e&tent that a company's policies arebenefiting stakeholder interests, notably shareholder interests. @ltimately, as ownersof the company, shareholders should hae some access to the board of directors if theyhae concerns or want something addressed. $herefore companies with goodgoernance gie shareholders a certain amount of ownership oting rights to callmeetings to discuss pressing issues with the board.

nother releant area for good goernance, in terms of ownership rights, is whether ornot a company possesses large amounts of takeoer defenses *such as the 4acaroniBefenseor the Poison Pill+ or other measures that make it difficult for changes inmanagement, directors and ownership to occur. *$o read more on takeoer strategies,see The Wacky World of M#As.+

Structure of the Board of !irectors

$he board of directors is composed of representaties from the company andrepresentaties from outside of the company. $he combination of inside and outsidedirectors attempts to proide an independent assessment of management's

performance, making sure that the interests of shareholders are represented.

$he key word when looking at the board of directors is independence. $he board ofdirectors is responsible for protecting shareholder interests and ensuring that the uppermanagement of the company is doing the same. $he board possesses the right to hireand fire members of the board on behalf of the shareholders. board filled withinsiderswill often not sere as objectie critics of management and will defend their

actions as good and beneficial, regardless of the circumstances.

"nformation on the board of directors of a publicly traded company *such asbiographies of indiidual board members and compensation-related info+ can be foundin the B5! >Lpro&y statement.

We'e now gone oer the business model, management and corporate goernance.$hese three areas are all important to consider when analy)ing any company. We willnow moe on to looking at (ualitatie factors in the enironment in which thecompany operates.

Fundamental Analysis: Qualitative Factors - The Industry

5ach industry has differences in terms of its customer base, market shareamong firms,

industry-wide growth, competition, regulation and business cycles. earning about

how the industry works will gie an inestor a deeper understanding of a company's

financial health.
http://www.investopedia.com/terms/m/macaronidefense.asphttp://www.investopedia.com/terms/m/macaronidefense.asphttp://www.investopedia.com/terms/p/poisonpill.asphttp://www.investopedia.com/articles/01/050901.asphttp://www.investopedia.com/articles/01/050901.asphttp://www.investopedia.com/terms/i/insider.asphttp://www.investopedia.com/terms/p/proxystatement.asphttp://www.investopedia.com/terms/p/proxystatement.asphttp://www.investopedia.com/terms/m/marketshare.asphttp://www.investopedia.com/terms/m/macaronidefense.asphttp://www.investopedia.com/terms/m/macaronidefense.asphttp://www.investopedia.com/terms/p/poisonpill.asphttp://www.investopedia.com/articles/01/050901.asphttp://www.investopedia.com/terms/i/insider.asphttp://www.investopedia.com/terms/p/proxystatement.asphttp://www.investopedia.com/terms/m/marketshare.asp


10/26

8ustomers

Some companies sere only a handful of customers, while others sere millions. "n

general, it's a red flag *a negatie+ if a business relies on a small number of customers

for a large portion of its sales because the loss of each customer could dramatically

affect reenues. !or e&ample, think of a military supplier who has >


11/26

the suppliers wanting to do business with them. "f you want to sell to Wal-4art, you

hae little, if any, pricing power.

+egulation

8ertain industries are heaily regulated due to the importance or seerity of theindustry's products and9or serices. s important as some of these regulations are to

the public, they can drastically affect the attractieness of a company for inestment

purposes.

"n industries where one or two companies represent the entire industry for a region

*such as utility companies+, goernments usually specify how much profit each

company can make. "n these instances, while there is the potential for si)able profits,

they are limited due to regulation.

"n other industries, regulation can play a less direct role in affecting industry pricing.

!or e&ample, the drug industry is one of most regulated industries. nd for good

reason - no one wants an ineffectie drug that causes deaths to reach the market. s a

result, the @.S.!ood and Brug dministration*!B+ re(uires that new drugs must

pass a series of clinical trials before they can be sold and distributed to the general

public. 3oweer, the conse(uence of all this testing is that it usually takes seeral

years and millions of dollars before a drug is approed. Aeep in mind that all these

costs are aboe and beyond the millions that the drug company has spent on researchand deelopment.

ll in all, inestors should always be on the lookout for regulations that could

potentially hae a material impact upon a business' bottom line. "nestors should keep

these regulatory costs in mind as they assess the potential risks and rewards of

inesting.

Fundamental Analysis: Introduction to Financial !tatements

$he massie amount of numbers in a company's financial statements can bebewildering and intimidating to many inestors. /n the other hand, if you know howto analy)e them, the financial statements are a gold mine of information.

!inancial statements are the medium by which a company discloses informationconcerning its financial performance. !ollowers of fundamental analysisuse the(uantitatieinformation gleaned from financial statements to make inestmentdecisions. #efore we jump into the specifics of the three most important financialstatements - income statements,balance sheetsandcash flow statements- we will

briefly introduce each financial statement's specific function, along with where theycan be found.
http://www.investopedia.com/terms/f/fda.asphttp://www.investopedia.com/terms/f/fundamentalanalysis.asphttp://www.investopedia.com/terms/q/quantitativeanalysis.asphttp://www.investopedia.com/terms/i/incomestatement.asphttp://www.investopedia.com/terms/b/balancesheet.asphttp://www.investopedia.com/terms/b/balancesheet.asphttp://www.investopedia.com/terms/c/cashflow.asphttp://www.investopedia.com/terms/c/cashflow.asphttp://www.investopedia.com/terms/f/fda.asphttp://www.investopedia.com/terms/f/fundamentalanalysis.asphttp://www.investopedia.com/terms/q/quantitativeanalysis.asphttp://www.investopedia.com/terms/i/incomestatement.asphttp://www.investopedia.com/terms/b/balancesheet.asphttp://www.investopedia.com/terms/c/cashflow.asp


12/26

The Ma"or !tatements

The Balance Sheet

$he balance sheet represents a record of a company's assets, liabilities and e(uity at aparticular point in time. $he balance sheet is named by the fact that a business'sfinancial structure balances in the following manner0

ssets O iabilities ShareholdersF'5(uity

ssets represent the resources that the business owns or controls at a gien point intime. $his includes items such as cash, inentory, machinery and buildings. $he otherside of the e(uation represents the total alue of the financing the company has usedto ac(uire those assets. !inancing comes as a result of liabilitiesor e(uity. iabilities

represent debt *which of course must be paid back+, while e(uity represents the totalalue of money that the owners hae contributed to the business - including retainedearnings, which is the profit made in preious years.

The Incoe Stateent

While the balance sheet takes a snapshot approach in e&amining a business, theincome statement measures a company's performance oer a specific time frame.$echnically, you could hae a balance sheet for a month or een a day, but you'll onlysee public companies report (uarterly and annually.

$he income statement presents information about reenues, e&penses and profit thatwas generated as a result of the business' operations for that period.

Stateent of Cash *lo&s

$he statement of cash flows represents a record of a business' cash inflows andoutflows oer a period of time. $ypically, a statement of cash flows focuses on thefollowing cash-related actiities0

/perating 8ash !low*/8!+0 8ash generated from day-to-day business

operations

8ash from inesting *8!"+0 8ash used for inesting in assets, as well as the

proceeds from the sale of other businesses, e(uipment or long-term assets

8ash from financing *8!!+0 8ash paid or receied from the issuing and

borrowing of funds

$he cash flow statement is important because it's ery difficult for a business tomanipulate its cash situation. $here is plenty that aggressie accountants can do to

manipulate earnings, but it's tough to fake cash in the bank. !or this reason someinestors use the cash flow statement as a more conseratie measure of a company's
http://www.investopedia.com/terms/l/liability.asphttp://www.investopedia.com/terms/e/equity.asphttp://www.investopedia.com/terms/o/operatingcashflow.asphttp://www.investopedia.com/terms/o/operatingcashflow.asphttp://www.investopedia.com/terms/l/liability.asphttp://www.investopedia.com/terms/e/equity.asphttp://www.investopedia.com/terms/o/operatingcashflow.asp


13/26

performance.

#$-% and #$-Q

1ow that you hae an understanding of what the three financial statements represent,let's discuss where an inestor can go about finding them. "n the @nited States, theSecurities nd 5&change 8ommission*S58+ re(uires all companies that are publiclytraded on a major e&change to submit periodic filings detailing their financialactiities, including the financial statements mentioned aboe.

Some other pieces of information that are also re(uired are an auditor's report,management discussion and analysis*4BH+ and a relatiely detailed description ofthe company's operations and prospects for the upcoming year.

ll of this information can be found in the business' annual >


14/26

4anagement Biscussion and nalysis *4BH+s a preface to the financial statements, a company's management will typically spenda few pages talking about the recent year *or (uarter+ and proide background on thecompany. $his is referred to as the management discussion and analysis*4BH+. "naddition to proiding inestorsa clearer picture of what the company does, the4BH also points out some key areas in which the company has performed well.

Bon't e&pect the letter from management to dele into all the juicy details affecting thecompany's performance. $he management's analysis is at their discretion, sounderstand they probably aren't going to be disclosing any negaties.

3ere are some things to look out for0

3ow candid and accurate are management's comments?

Boes management discuss significant financial trends oer the past couple

years? *s we'e already mentioned, it can be interesting to compare the4BHs oer the last few years to see how the message has changed andwhether management actually followed through with its plan.+

3ow clear are management's comments? "f e&ecuties try to confuse you with

big words and jargon, perhaps they hae something to hide.

Bo they mention potential risks or uncertainties moing forward?

Bisclosure is the name of the game. "f a company gies a decent amount ofinformation in the 4BH, it's likely that management is being upfront and honest. "tshould raise a red flag if the 4BH ignores serious problems that the company has

been facing.

The Auditor(s )eport$he auditors' job is to e&press an opinion on whether the financialstatements arereasonably accurate and proide ade(uate disclosure. $his is the purpose behind theauditor's report, which is sometimes called the %report of independent accountants%.

#y law, eery public company that trades stocks or bonds on an e&change must haeitsannual reportsaudited by a certified public accountants firm. n auditor's report ismeant to scrutini)e the company and identify anything that might undermine theintegrity of the financial statements.

$he typical auditor's report is almost always broken into three paragraphs and writtenin the following fashion0

Independent Auditor*(s )eport

+aragraph #
http://www.investopedia.com/terms/m/mdanalysis.asphttp://www.investopedia.com/terms/m/mdanalysis.asphttp://www.investopedia.com/university/fundamentalanalysis/managementdiscussion.asp#%23http://www.investopedia.com/university/fundamentalanalysis/auditorsreport.asp#%23http://www.investopedia.com/terms/a/auditorsreport.asphttp://www.investopedia.com/university/fundamentalanalysis/auditorsreport.asp#%23http://www.investopedia.com/university/fundamentalanalysis/auditorsreport.asp#%23http://www.investopedia.com/terms/c/cpa.asphttp://www.investopedia.com/university/fundamentalanalysis/auditorsreport.asp#%23http://www.investopedia.com/terms/m/mdanalysis.asphttp://www.investopedia.com/university/fundamentalanalysis/managementdiscussion.asp#%23http://www.investopedia.com/university/fundamentalanalysis/auditorsreport.asp#%23http://www.investopedia.com/terms/a/auditorsreport.asphttp://www.investopedia.com/university/fundamentalanalysis/auditorsreport.asp#%23http://www.investopedia.com/terms/c/cpa.asphttp://www.investopedia.com/university/fundamentalanalysis/auditorsreport.asp#%23


15/26

ecounts the responsibilities of the auditor and directors in general andlists the areas of the financial statements that were audited.+aragraph ,ists how the generally accepted accounting principles*JP+ were

applied, and what areas of the company were assessed.+aragraph Proides the auditorF's opinion on the financial statements of the company

being audited. $his is simply an opinion, not a guarantee of accuracy.

While the auditor's report won't uncoer any financial bombshells, audits giecredibility to the figures reported by management. 2ou'll only see unaudited financialsfor unlisted firms *those that trade /$8## or on the Pink Sheets+. While (uarterlystatements aren't audited, you should be ery wary of any annual financials thathaen't been gien the accountants' stamp of approal.

The &otes to the Financial !tatementsGust as the 4BH seres an introduction to the financial statements, the notes to thefinancialstatements *sometimes called footnotes+ tie up any loose ends and completethe oerall picture. "f the incomestatement, balance sheet and statement of cash flowsare the heart of the financial statements,then the footnotes are the arteries that keepeerything connected. $herefore, if you aren't reading the footnotes, you're missingout on a lot of information.

$he footnotes list important information that could not be included in the actualledgers. !or e&ample, they list releant things like outstanding leases, the maturitydatesof outstanding debt and details on compensation plans, such as stock options,etc.

Jenerally speaking there are two types of footnotes0Accounting Methods- $his type of footnote identifies and e&plains the majoraccounting policies of the business that the company feels that you should be aware

of. $his is especially important if a company has changed accounting policies. "t maybe that a firm is practicing %cookie jar accounting% and is changing policies only totake adantage of current conditions in order to hide poor performance.

.isclosure- $he second type of footnote proides additional disclosure that simplycould not be put in the financial statements. $he financial statements in an annualreportare supposed to be clean and easy to follow. $o maintain this cleanliness, othercalculations are left for the footnotes. !or e&ample, details of long-term debt - such asmaturity dates and the interest rates at which debt was issued - can gie you a betteridea of how borrowing costs are laid out. /ther areas of disclosure include eerything

from pension plan liabilities for e&isting employees to details about ominous legalproceedings inoling the company.
http://www.investopedia.com/terms/g/gaap.asphttp://www.investopedia.com/university/fundamentalanalysis/notes.asp#%23http://www.investopedia.com/terms/f/footnote.asphttp://www.investopedia.com/university/fundamentalanalysis/notes.asp#%23http://www.investopedia.com/university/fundamentalanalysis/notes.asp#%23http://www.investopedia.com/university/fundamentalanalysis/notes.asp#%23http://www.investopedia.com/university/fundamentalanalysis/notes.asp#%23http://www.investopedia.com/terms/m/maturitydate.asphttp://www.investopedia.com/terms/m/maturitydate.asphttp://www.investopedia.com/terms/c/cookiejaraccounting.asphttp://www.investopedia.com/terms/a/annualreport.asphttp://www.investopedia.com/terms/a/annualreport.asphttp://www.investopedia.com/terms/g/gaap.asphttp://www.investopedia.com/university/fundamentalanalysis/notes.asp#%23http://www.investopedia.com/terms/f/footnote.asphttp://www.investopedia.com/university/fundamentalanalysis/notes.asp#%23http://www.investopedia.com/university/fundamentalanalysis/notes.asp#%23http://www.investopedia.com/university/fundamentalanalysis/notes.asp#%23http://www.investopedia.com/terms/m/maturitydate.asphttp://www.investopedia.com/terms/m/maturitydate.asphttp://www.investopedia.com/terms/c/cookiejaraccounting.asphttp://www.investopedia.com/terms/a/annualreport.asphttp://www.investopedia.com/terms/a/annualreport.asp


16/26

$he majority of inestors and analysts read the balance sheet, income statement andcash flow statement but, for whateer reason, the footnotes are often ignored. Whatsets informed inestors apart is digging deeper and looking for information that otherstypically wouldn't. 1o matter how boring it might be, read the fine print - it will makeyou a better inestor.

Fundamental Analysis: The Income Statement

$he income statementis basically the first financial statement you will come across in

an annual report or (uarterly Securities nd 5&change 8ommission*S58+ filing.

"t also contains the numbers most often discussed when a company announces its

results- numbers such as reenue,earningsand earnings per share. #asically, theincome statement shows how much money the company generated *reenue+, how

much it spent *e&penses+ and the difference between the two *profit+ oer a certain

time period.

When it comes to analy)ing fundamentals, the income statement lets inestors know

how well the company's business is performing - or, basically, whether or not the

company is making money. Jenerally speaking, companies ought to be able to bring

in more money than they spend or they don't stay in business for long. $hose

companies with low e&penses relatie to reenue - or high profits relatie to reenue -signal strong fundamentals to inestors.

)evenue as an investor signal

eenue, also commonly known as sales, is generally the most straightforward part of

the income statement. /ften, there is just a single number that represents all the

money a company brought in during a specific time period, although big companies

sometimes break down reenue by business segment or geography.

$he best way for a company to improe profitability is by increasing sales reenue.

!or instance, Starbucks 8offee has aggressie long-term sales growth goals that

include a distribution system of ;


17/26

$here are many kinds of e&penses, but the two most common are the cost of goods

sold*8/JS+ and selling, general and administratie e&penses*SJH+. 8ost of goods

sold is the e&pense most directly inoled in creating reenue. "t represents the costs

of producing or purchasing the goods or serices sold by the company. !or e&ample, if

Wal-4art pays a supplier :L for a bo& of soap, which it sells to customers for :=.When it is sold, Wal-4art's cost of good sold for the bo& of soap would be :L.

1e&t, costs inoled in operating the business are SJH. $his category includes

marketing, salaries, utility bills, technology e&penses and other general costs

associated with running a business. SJH also includes depreciationand

amorti)ation. 8ompanies must include the cost of replacing worn out assets.

emember, some corporate e&penses, such as research and deelopment*HB+ at

technology companies, are crucial to future growth and should not be cut, een though

doing so may make for a better-looking earnings report. !inally, there are financialcosts, notably ta&es and interest payments, which need to be considered.

+rofits 3 )evenue - 01penses

Profit, most simply put, is e(ual to total reenue minus total e&penses. 3oweer, there

are seeral commonly used profit subcategories that tell inestors how the company is

performing. Jross profit is calculated as reenue minus cost of sales. eturning to

Wal-4art again, the gross profit from the sale of the soap would hae been :> *:=

sales price less :L cost of goods sold O :> gross profit+.

8ompanies with high gross marginswill hae a lot of money left oer to spend on

other business operations, such as HB or marketing. So be on the lookout for

downward trends in the gross margin rate oer time. $his is a telltale sign of future

problems facing the bottom line. When cost of goods sold rises rapidly, they are likely

to lower gross profit margins - unless, of course, the company can pass these costs

onto customers in the form of higher prices.

/perating profitis e(ual to reenues minus the cost of sales and SJH. $his numberrepresents the profit a company made from its actual operations, and e&cludes certain

e&penses and reenues that may not be related to its central operations. 3igh operating

margins can mean the company has effectie control of costs, or that sales are

increasing faster than operating costs. /perating profit also gies inestors an

opportunity to do profit-margin comparisons between companies that do not issue a

separate disclosure of their cost of goods sold figures *which are needed to do gross

margin analysis+. /perating profit measures how much cash the business throws off,

and some consider it a more reliable measure of profitability since it is harder to

manipulate with accounting tricks than net earnings.
http://www.investopedia.com/terms/c/cogs.asphttp://www.investopedia.com/terms/c/cogs.asphttp://www.investopedia.com/terms/s/sga.asphttp://www.investopedia.com/terms/d/depreciation.asphttp://www.investopedia.com/terms/a/amortization.asphttp://www.investopedia.com/terms/r/randd.asphttp://www.investopedia.com/terms/g/grossmargin.asphttp://www.investopedia.com/terms/o/operatingincome.asphttp://www.investopedia.com/terms/c/cogs.asphttp://www.investopedia.com/terms/c/cogs.asphttp://www.investopedia.com/terms/s/sga.asphttp://www.investopedia.com/terms/d/depreciation.asphttp://www.investopedia.com/terms/a/amortization.asphttp://www.investopedia.com/terms/r/randd.asphttp://www.investopedia.com/terms/g/grossmargin.asphttp://www.investopedia.com/terms/o/operatingincome.asp


18/26

1et income generally represents the company's profit after all e&penses, including

financial e&penses, hae been paid. $his number is often called the %bottom line% and

is generally the figure people refer to when they use the word %profit% or %earnings%.

When a company has a high proft margin, it usually means that italso has one or more advantages over its competition !ompanies

"ith high net proft margins have a #igger cushion to protect

themselves during the hard times !ompanies "ith lo" proft

margins can get "iped out in a do"nturn And companies "ith proft

margins re$ecting a competitive advantage are a#le to improve

their mar%et share during the hard times - leaving them even #etter

positioned "hen things improve again

Conclusion

&ou can gain valua#le insights a#out a company #y e'amining its

income statement Increasing sales o(ers the frst sign o) strong

)undamentals *ising margins indicate increasing e+ciency and

profta#ility Its also a good idea to determine "hether the company

is per)orming in line "ith industry peers and competitors oo% )or

signifcant changes in revenues, costs o) goods sold and S./A to

get a sense o) the companys proft )undamentals

Fundamental Analysis: The 0alance Sheet

#y "nestopedia Staff

#y #en 4c8lure

"nestors often oerlook thebalance sheet. ssets and liabilities aren't nearly as se&y

as reenueandearnings. While earnings are important, they don't tell the whole story.

$he balance sheet highlights the financial condition of a company and is an integral

part of the financial statements. *$o read more on financial statement basics, see What

/ou eed To no& A2out *inancial StateentsandAdvanced *inancial Stateent

Analysis.+

The !napshot of 4ealth

$he balance sheet, also known as the statement of financial condition, offers a

snapshot of a company's health. "t tells you how much a company owns *its assets+,

and how much it owes *its liabilities+. $he difference between what it owns and what
http://www.investopedia.com/terms/b/bottomline.asphttp://www.investopedia.com/contributors/79/http://www.investopedia.com/contributors/79/http://www.investopedia.com/contributors/?id=49http://www.investopedia.com/terms/b/balancesheet.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/e/earnings.asphttp://www.investopedia.com/terms/e/earnings.asphttp://www.investopedia.com/articles/basics/06/financialreporting.asphttp://www.investopedia.com/articles/basics/06/financialreporting.asphttp://www.investopedia.com/university/financialstatements/http://www.investopedia.com/university/financialstatements/http://www.investopedia.com/terms/b/bottomline.asphttp://www.investopedia.com/contributors/79/http://www.investopedia.com/contributors/?id=49http://www.investopedia.com/terms/b/balancesheet.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/e/earnings.asphttp://www.investopedia.com/articles/basics/06/financialreporting.asphttp://www.investopedia.com/articles/basics/06/financialreporting.asphttp://www.investopedia.com/university/financialstatements/http://www.investopedia.com/university/financialstatements/


19/26

it owes is its e(uity, also commonly called %net assets% or %shareholders e(uity%.

$he balance sheet tells inestors a lot about a company's fundamentals0 how much

debtthe company has, how much it needs to collect from customers *and how fast it

does so+, how much cash and e(uialents it possesses and what kinds of funds thecompany has generated oer time.

$o learn more, check out our 5alance sheet video0

The Balance !heet(s Main Three

ssets, liability and e(uity are the three main components of the balance sheet.

8arefully analy)ed, they can tell inestors a lot about a company's fundamentals.

Assets

$here are two main types of assets0 current assetsand non-current assets. 8urrent

assets are likely to be used up or conerted into cash within one business cycle -

usually treated as twele months. $hree ery important current asset items found on

the balance sheet are0 cash, inentoriesand accounts receiables.

"nestors normally are attracted to companies with plenty of cash on their balance

sheets. fter all, cash offers protection against tough times, and it also gies

companies more options for future growth. Jrowing cash reseres often signal strong

company performance. "ndeed, it shows that cash is accumulating so (uickly that

management doesn't hae time to figure out how to make use of it. dwindling cash

pile could be a sign of trouble. $hat said, if loads of cash are more or less a permanent

feature of the company's balance sheet, inestors need to ask why the money is not
http://www.investopedia.com/terms/e/equity.asphttp://www.investopedia.com/terms/f/fundamentals.asphttp://www.investopedia.com/terms/d/debt.asphttp://www.investopedia.com/terms/c/currentassets.asphttp://www.investopedia.com/terms/c/cash.asphttp://www.investopedia.com/terms/i/inventory.asphttp://www.investopedia.com/terms/a/accountsreceivable.asphttp://www.investopedia.com/terms/g/growthrates.asphttp://www.investopedia.com/terms/e/equity.asphttp://www.investopedia.com/terms/f/fundamentals.asphttp://www.investopedia.com/terms/d/debt.asphttp://www.investopedia.com/terms/c/currentassets.asphttp://www.investopedia.com/terms/c/cash.asphttp://www.investopedia.com/terms/i/inventory.asphttp://www.investopedia.com/terms/a/accountsreceivable.asphttp://www.investopedia.com/terms/g/growthrates.asp


20/26

being put to use. 8ash could be there because management has run out of inestment

opportunities or is too short-sighted to know what to do with the money.

"nentories are finished products that haen't yet sold. s an inestor, you want to

know if a company has too much money tied up in its inentory. 8ompanies haelimited funds aailable to inest in inentory. $o generate the cash to pay bills and

return a profit, they must sell the merchandise they hae purchased from suppliers.

"nentory turnoer*cost of goods solddiided by aerage inentory+ measures how

(uickly the company is moing merchandise through the warehouse to customers. "f

inentory grows faster than sales, it is almost always a sign of deteriorating

fundamentals.

eceiablesare outstanding *uncollected bills+. naly)ing the speed at which a

company collects what it's owed can tell you a lot about its financial efficiency. "f acompany's collection period is growing longer, it could mean problems ahead. $he

company may be letting customers stretch their credit in order to recogni)e greater

top-line sales and that can spell trouble later on, especially if customers face a cash

crunch. Jetting money right away is preferable to waiting for it - since some of what

is owed may neer get paid. $he (uicker a company gets its customers to make

payments, the sooner it has cash to pay for salaries, merchandise, e(uipment, loans,

and best of all, diidends and growth opportunities.

1on-current assets are defined as anything not classified as a current asset. $his

includes items that are fi&ed assets, such asproperty, plant and e(uipment*PPH5+.

@nless the company is in financial distress and is li(uidatingassets, inestors need not

pay too much attention to fi&ed assets. Since companies are often unable to sell their

fi&ed assets within any reasonable amount of time they are carried on the balance

sheet at cost regardless of their actual alue. s a result, it's is possible for companies

to grossly inflate this number, leaing inestors with (uestionable and hard-to-

compare asset figures.

3ia2ilities

$here are current liabilitiesand non-current liabilities. 8urrent liabilities are

obligations the firm must pay within a year, such as payments owing to suppliers.

1on-current liabilities, meanwhile, represent what the company owes in a year or

more time. $ypically, non-current liabilities represent bank and bondholder debt.

2ou usually want to see a manageable amount of debt. When debt leels are falling,

that's a good sign. Jenerally speaking, if a company has more assets than liabilities,

then it is in decent condition. #y contrast, a company with a large amount of liabilitiesrelatie to assets ought to be e&amined with more diligence. 3aing too much debt
http://www.investopedia.com/terms/i/inventoryturnover.asphttp://www.investopedia.com/terms/c/cogs.asphttp://www.investopedia.com/terms/r/receivables.asphttp://www.investopedia.com/terms/f/fixedasset.asphttp://www.investopedia.com/terms/p/ppe.asphttp://www.investopedia.com/terms/l/liquidate.asphttp://www.investopedia.com/terms/c/currentliabilities.asphttp://www.investopedia.com/terms/i/inventoryturnover.asphttp://www.investopedia.com/terms/c/cogs.asphttp://www.investopedia.com/terms/r/receivables.asphttp://www.investopedia.com/terms/f/fixedasset.asphttp://www.investopedia.com/terms/p/ppe.asphttp://www.investopedia.com/terms/l/liquidate.asphttp://www.investopedia.com/terms/c/currentliabilities.asp


21/26

relatie to cash flows re(uired to pay for interest and debt repayments is one way a

company can gobankrupt.

ook at the (uick ratio. Subtract inentory from current assets and then diide by

current liabilities. "f the ratio is > or higher, it says that the company has enough cashand li(uid assets to coer its short-term debt obligations.

6uick atio O

8urrent ssets - "nentories

8urrent iabilities

.4uity5(uity represents what shareholders own, so it is often called shareholder's e(uity. s

described aboe, e(uity is e(ual to total assets minus total liabilities.

5(uity O $otal ssets 7 $otal iabilities

$he two important e(uity items arepaid-in capitaland retained earnings. Paid-in

capital is the amount of money shareholders paid for their shares when the stock was

first offeredto the public. "t basically represents how much money the firm receied

when it sold its shares. "n other words, retained earnings are a tally of the money the

company has chosen to reinest in the business rather than pay to shareholders.

"nestors should look closely at how a company puts retained capital to use and how a

company generates a return on it.

4ost of the information about debt can be found on the balance sheet - but some

assets and debt obligations are not disclosed there. !or starters, companies often

possess hard-to-measure intangible assets. 8orporate intellectual property*items such

aspatents, trademarks, copyrights and business methodologies+, goodwillandbrand

recognitionare all common assets in today's marketplace. #ut they are not listed on

company's balance sheets.

$here is also off-balance sheetdebt to be aware of. $his is form of financing in which

large capital e&penditures are kept off of a company's balance sheet through arious

classification methods. 8ompanies will often use off-balance-sheet financing to keep

the debt leels low. *$o continue reading about the balance sheet, see+eading The
http://www.investopedia.com/terms/b/bankruptcy.asphttp://www.investopedia.com/terms/q/quickratio.asphttp://www.investopedia.com/terms/p/paidincapital.asphttp://www.investopedia.com/terms/r/retainedearnings.asphttp://www.investopedia.com/terms/i/ipo.asphttp://www.investopedia.com/terms/i/intellectualproperty.asphttp://www.investopedia.com/terms/p/patent.asphttp://www.investopedia.com/terms/t/trademark.asphttp://www.investopedia.com/terms/g/goodwill.asphttp://www.investopedia.com/terms/b/brandawareness.asphttp://www.investopedia.com/terms/b/brandawareness.asphttp://www.investopedia.com/terms/b/brandawareness.asphttp://www.investopedia.com/terms/o/obsf.asphttp://www.investopedia.com/articles/04/031004.asphttp://www.investopedia.com/terms/b/bankruptcy.asphttp://www.investopedia.com/terms/q/quickratio.asphttp://www.investopedia.com/terms/p/paidincapital.asphttp://www.investopedia.com/terms/r/retainedearnings.asphttp://www.investopedia.com/terms/i/ipo.asphttp://www.investopedia.com/terms/i/intellectualproperty.asphttp://www.investopedia.com/terms/p/patent.asphttp://www.investopedia.com/terms/t/trademark.asphttp://www.investopedia.com/terms/g/goodwill.asphttp://www.investopedia.com/terms/b/brandawareness.asphttp://www.investopedia.com/terms/b/brandawareness.asphttp://www.investopedia.com/terms/o/obsf.asphttp://www.investopedia.com/articles/04/031004.asp


22/26

Balance Sheet,Testing Balance Sheet StrengthandBreaking !o&n The Balance

Sheet.+

Fundamental Analysis: The !ash Flo" Statement


#y #en 4c8lure

$he cash flow statementshows how much cash comes in and goes out of the company

oer the (uarteror the year. t first glance, that sounds a lot like the income statement

in that it records financial performance oer a specified period. #ut there is a big

difference between the two.

What distinguishes the two is accrual accounting, which is found on the income

statement. ccrual accounting re(uires companies to record reenuesand e&penses

when transactions occur, not when cash is e&changed. t the same time, the income

statement, on the other hand, often includes non-cash reenues or e&penses, which the

statement of cash flows does not include.

Gust because the income statement shows net income of :>< does not means that cash

on the balance sheet will increase by :>< net cash inflow, that's e&actly what it means. $he company has

:>< more in cash than at the end of the last financial period. 2ou may want to think of

net cash from operationsas the company's %true% cashprofit.

#ecause it shows how much actual cash a company has generated, the statement of

cash flows is critical to understanding a company's fundamentals. "t shows how the

company is able to pay for its operations and future growth.

"ndeed, one of the most important features you should look for in a potential

inestment is the company's ability to produce cash. Gust because a company shows a

profit on the income statement doesn't mean it cannot get into trouble later because of

insufficient cash flows. close e&amination of the cash flow statement can gie

inestors a better sense of how the company will fare.

Three !ections of the Cash Flo6 !tatement

8ompanies produce and consume cash in different ways, so the cash flow statement is

diided into three sections0 cash flows from operations, financingand inesting.#asically, the sections on operations and financing show how the company gets its
http://www.investopedia.com/articles/04/031004.asphttp://www.investopedia.com/articles/basics/06/assetperformance.asphttp://www.investopedia.com/articles/basics/06/assetperformance.asphttp://www.investopedia.com/articles/basics/06/balancesheet.asphttp://www.investopedia.com/articles/basics/06/balancesheet.asphttp://www.investopedia.com/contributors/79/http://www.investopedia.com/contributors/79/http://www.investopedia.com/contributors/?id=49http://www.investopedia.com/terms/c/cashflowstatement.asphttp://www.investopedia.com/terms/q/quarter.asphttp://www.investopedia.com/terms/i/incomestatement.asphttp://www.investopedia.com/terms/a/accrualaccounting.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/e/expense.asphttp://www.investopedia.com/terms/o/operatingcashflow.asphttp://www.investopedia.com/terms/p/profit.asphttp://www.investopedia.com/terms/p/profit.asphttp://www.investopedia.com/terms/f/fundamentals.asphttp://www.investopedia.com/terms/c/cashflowfromfinancing.asphttp://www.investopedia.com/terms/c/cashflowfinvestingactivities.asphttp://www.investopedia.com/articles/04/031004.asphttp://www.investopedia.com/articles/basics/06/assetperformance.asphttp://www.investopedia.com/articles/basics/06/balancesheet.asphttp://www.investopedia.com/articles/basics/06/balancesheet.asphttp://www.investopedia.com/contributors/79/http://www.investopedia.com/contributors/?id=49http://www.investopedia.com/terms/c/cashflowstatement.asphttp://www.investopedia.com/terms/q/quarter.asphttp://www.investopedia.com/terms/i/incomestatement.asphttp://www.investopedia.com/terms/a/accrualaccounting.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/e/expense.asphttp://www.investopedia.com/terms/o/operatingcashflow.asphttp://www.investopedia.com/terms/p/profit.asphttp://www.investopedia.com/terms/f/fundamentals.asphttp://www.investopedia.com/terms/c/cashflowfromfinancing.asphttp://www.investopedia.com/terms/c/cashflowfinvestingactivities.asp


23/26

cash, while the inesting section shows how the company spends its cash. *$o

continue learning about cash flow, see The .ssentials %f Cash *lo&, %'erating Cash

*lo&5 Better Than et Incoe?andWhat Is A Cash *lo& Stateent?+

Cash *lo&s fro %'erating Activities$his section shows how much cash comes from sales of the company's goods and

serices, less the amount of cash needed to make and sell those goods and serices.

"nestors tend to prefer companies that produce a net positie cash flow from

operating actiities. 3igh growth companies, such as technology firms, tend to show

negatie cash flow from operations in their formatie years. t the same time, changes

in cash flow from operations typically offer a preiew of changes in net future income.

1ormally it's a good sign when it goes up. Watch out for a widening gap between a

company's reported earnings and its cash flow from operating actiities. "f net income

is much higher than cash flow, the company may be speeding or slowing its booking

of income or costs.

Cash *lo&s fro Investing Activities

$his section largely reflects the amount of cash the company has spent on capital

e&penditures, such as new e(uipment or anything else that needed to keep the business

going. "t also includes ac(uisitions of other businesses and monetary inestments such

as money market funds.

2ou want to see a company re-inest capital in its business by at least the rate of

depreciatione&penses each year. "f it doesn't re-inest, it might show artificially high

cash inflows in the current year which may not be sustainable.

Cash *lo& *ro *inancing Activities

$his section describes the goings-on of cash associated with outside financing

actiities. $ypical sources of cash inflow would be cash raised by selling stock and

bonds or by bank borrowings. ikewise, paying back a bank loan would show up as a

use of cash flow, as would diidend paymentsand common stock repurchases.

Cash Flo6 !tatement Considerations:

Say inestors are attracted to companies that produce plenty of free cash flow

*!8!+. !ree cash flow signals a company's ability to pay debt, pay diidends, buy

back stock and facilitate the growth of business. !ree cash flow, which is essentially

the e&cess cash produced by the company, can be returned to shareholders or inested

in new growth opportunities without hurting the e&isting operations. $he most

common method of calculating free cash flow is0
http://www.investopedia.com/articles/01/110701.asphttp://www.investopedia.com/articles/analyst/03/122203.asphttp://www.investopedia.com/articles/analyst/03/122203.asphttp://www.investopedia.com/articles/04/033104.asphttp://www.investopedia.com/articles/04/033104.asphttp://www.investopedia.com/terms/n/netincome.asphttp://www.investopedia.com/terms/c/capitalexpenditure.asphttp://www.investopedia.com/terms/c/capitalexpenditure.asphttp://www.investopedia.com/terms/d/depreciation.asphttp://www.investopedia.com/terms/d/dividend.asphttp://www.investopedia.com/terms/f/freecashflow.asphttp://www.investopedia.com/articles/01/110701.asphttp://www.investopedia.com/articles/analyst/03/122203.asphttp://www.investopedia.com/articles/analyst/03/122203.asphttp://www.investopedia.com/articles/04/033104.asphttp://www.investopedia.com/terms/n/netincome.asphttp://www.investopedia.com/terms/c/capitalexpenditure.asphttp://www.investopedia.com/terms/c/capitalexpenditure.asphttp://www.investopedia.com/terms/d/depreciation.asphttp://www.investopedia.com/terms/d/dividend.asphttp://www.investopedia.com/terms/f/freecashflow.asp


24/26

Ideally, investors "ould li%e to see that the company can pay )or the

investing fgure out o) operations "ithout having to rely on outside

fnancing to do so A companys a#ility to pay )or its o"n operations

and gro"th signals to investors that it has very strong )undamentals

Fundamental Analysis: A 0rie) Introduction To 1aluation


#y #en 4c8lure

While the concept behind discounted cash flowanalysis is simple, its practical

application can be a different matter. $he premise of the discounted cash flow method

is that the current alue of a company is simply the present alue of its future cash

flows that are attributable to shareholders. "ts calculation is as follows0

!or simplicity's sake, if we know that a company will generate :> per share in cash

flow for shareholders eery year into the future we can calculate what this type of

cash flow is worth today. $his alue is then compared to the current alue of thecompany to determine whether the company is a good inestment, based on it being

underalued or oeralued.

$here are seeral different techni(ues within the discounted cash flow realm of

aluation, essentially differing on what type of cash flow is used in the analysis. $he

diidend discount modelfocuses on the diidends the company pays to shareholders,

while the cash flow model looks at the cash that can be paid to shareholders after all

e&penses, reinestments and debt repayments hae been made. #ut conceptually they

are the same, as it is the present alue of these streams that are taken into
http://www.investopedia.com/contributors/79/http://www.investopedia.com/contributors/79/http://www.investopedia.com/contributors/?id=49http://www.investopedia.com/terms/d/dcf.asphttp://www.investopedia.com/terms/d/ddm.asphttp://www.investopedia.com/contributors/79/http://www.investopedia.com/contributors/?id=49http://www.investopedia.com/terms/d/dcf.asphttp://www.investopedia.com/terms/d/ddm.asp


25/26

consideration.

s we mentioned before, the difficulty lies in the implementation of the model as

there are a considerable amount of estimates and assumptions that go into the model.

s you can imagine, forecasting the reenue and e&penses for a firm fie or >< yearsinto the future can be considerably difficult. 1eertheless, B8! is a aluable tool used

by both analysts and eeryday inestors to estimate a company's alue.

!or more information and in-depth instructions, see the!iscounted Cash *lo&

Analysistutorial.

)atio Valuation

!inancial ratios are mathematical calculations using figures mainly from the financial

statements, and they are used to gain an idea of a company's aluation and financial

performance. Some of the most well-known aluation ratios areprice-to-earningsand

price-to-book. 5ach aluation ratio uses different measures in its calculations. !or

e&ample, price-to-book compares the price per share to the company's book alue.

$he calculations produced by the aluation ratios are used to gain some understanding

of the company's alue. $he ratios are compared on an absolute basis, in which there

are threshold alues. !or e&ample, in price-to-book, companies trading below '>' are

considered underalued. aluation ratios are also compared to the historical alues ofthe ratio for the company, along with comparisons to competitors and the oerall

market itself.

Fundamental Analysis: !onclusion

Wheneer you're thinking of inesting in a company it is ital that you understandwhat it does, its market and the industry in which it operates. 2ou should neer blindlyinest in a company.

/ne of the most important areas for any inestor to look at when researching acompany is the financial statements. "t is essential to understand the purpose of each

part of these statements and how to interpret them.

et's recap what we'e learned0

!inancial reports are re(uired by law and are published both (uarterlyand

annually.
http://www.investopedia.com/university/dcf/http://www.investopedia.com/university/dcf/http://www.investopedia.com/terms/p/price-earningsratio.asphttp://www.investopedia.com/terms/p/price-to-bookratio.asphttp://www.investopedia.com/university/fundamentalanalysis/auditorsreport.asp#%23http://www.investopedia.com/terms/q/quarter.asphttp://www.investopedia.com/university/fundamentalanalysis/annualreport.asp#%23http://www.investopedia.com/university/dcf/http://www.investopedia.com/university/dcf/http://www.investopedia.com/terms/p/price-earningsratio.asphttp://www.investopedia.com/terms/p/price-to-bookratio.asphttp://www.investopedia.com/university/fundamentalanalysis/auditorsreport.asp#%23http://www.investopedia.com/terms/q/quarter.asphttp://www.investopedia.com/university/fundamentalanalysis/annualreport.asp#%23


26/26

4anagement discussion and analysis*4BH+ gies inestors a better

understanding of what the company does and usually points out some key areaswhere it performed well.

udited financial reportshae much more credibility than unaudited ones.

$hebalance sheetlists the assets, liabilities and shareholders' e(uity.

!or all balance sheets0 ssetsO iabilities Shareholders' 5(uity. $he two

sides must always e(ual each other *or balance each other+.

$he income statementincludes figures such as reenue,e&penses, earningsand

earnings per share.

!or a company, the top line is reenue while thebottom lineis net income.

$he income statement takes into account some non-cash items, such as

depreciation.

$he cash flow statementstrips away all non-cash items and tells you how much

actual money the company generated.

$he cash flow statement is diided into three parts0 cash from operations,

financingand inesting.

lways read the notes to the financial statements. $hey proide more in-depth

information on a wide range of figures reported in the three financialstatements.
http://www.investopedia.com/terms/m/mdanalysis.asphttp://www.investopedia.com/terms/a/auditorsreport.asphttp://www.investopedia.com/terms/b/balancesheet.asphttp://www.investopedia.com/terms/a/asset.asphttp://www.investopedia.com/terms/l/liability.asphttp://www.investopedia.com/terms/s/stockholdersequity.asphttp://www.investopedia.com/terms/i/incomestatement.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/e/expense.asphttp://www.investopedia.com/terms/e/earnings.asphttp://www.investopedia.com/terms/e/eps.asphttp://www.investopedia.com/terms/b/bottomline.asphttp://www.investopedia.com/terms/c/cashflowstatement.asphttp://www.investopedia.com/terms/o/operatingcashflow.asphttp://www.investopedia.com/terms/c/cashflowfromfinancing.asphttp://www.investopedia.com/terms/c/cashflowfinvestingactivities.asphttp://www.investopedia.com/terms/m/mdanalysis.asphttp://www.investopedia.com/terms/a/auditorsreport.asphttp://www.investopedia.com/terms/b/balancesheet.asphttp://www.investopedia.com/terms/a/asset.asphttp://www.investopedia.com/terms/l/liability.asphttp://www.investopedia.com/terms/s/stockholdersequity.asphttp://www.investopedia.com/terms/i/incomestatement.asphttp://www.investopedia.com/terms/r/revenue.asphttp://www.investopedia.com/terms/e/expense.asphttp://www.investopedia.com/terms/e/earnings.asphttp://www.investopedia.com/terms/e/eps.asphttp://www.investopedia.com/terms/b/bottomline.asphttp://www.investopedia.com/terms/c/cashflowstatement.asphttp://www.investopedia.com/terms/o/operatingcashflow.asphttp://www.investopedia.com/terms/c/cashflowfromfinancing.asphttp://www.investopedia.com/terms/c/cashflowfinvestingactivities.asp

fundamental analysis of balance sheet

Documents