what does laissez faire mean

8/9/2019 What Does Laissez Faire Mean

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What Does Laissez Faire Mean?

An economic theory from the 18th century that is strongly opposed to any government intervention in

business affairs.

Sometimes referred to as "let it be economics."

People who support a laissez faire system are against minimum wages, duties, and any other traderestrictions.

Laissez faire is French for "leave alone."

1-Fiscal policyis the means by which a government adjusts its levels of spending in order to monitor and

influence a nation's economy. It is the sister strategy to monetary policywith which a central bank

influences a nation's money supply. These two policies are used in various combinations in an effort to

direct a country's economic goals. Here we take a look at how fiscal policy works, how it must be

monitored and how its implementation may affect different people in an economy. (For background on

fiscal policies, seeFormulating Monetary Policy.),

Before the Great Depression in the United States, the government's approach to the economy was

laissez faire. But following the Second World War, it was determined that the government had to take a

proactive role in the economy to regulate unemployment, business cycles, inflationand the cost of

money. By using a mixture of both monetary and fiscal policies (depending on the political orientations

and the philosophies of those in power at a particular time, one policy may dominate over another),

governments are able to control economic phenomena.

How Fiscal Policy Works

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known asKeynesian economics, this theory basically states that governments can influence macroeconomic

productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn,

curbs inflation (generally considered to be healthy when at a level between 2-3%), increases employment

and maintains a healthy value of money. (To read more on this subject, see Can Keynesian Economics

Reduce Boom-Bust Cycles?andHow Influential Economists Changed Our History.)

Balancing Act

The idea, however, is to find a balance in exercising these influences. For example, stimulating a

stagnant economy runs the risk of rising inflation. This is because an increase in the supply of money

followed by an increase in consumer demand can result in a decrease in the value of money - meaning

that it will take more money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down

and businesses are not making any money. A government thus decides to fuel the economy's engine by

decreasing taxation, giving consumers more spending money while increasing government spending in

the form of buying services from the market (such as building roads or schools). By paying for such

services, the government creates jobs and wages that are in turn pumped into the economy. Pumping

money into the economy is also known as "pump priming". In the meantime, overall unemployment levels

will fall. (To learn more about inflation and employement, see Surveying The Employment Reportand
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The Importance Of Inflation And GDP.)

With more money in the economy and less taxes to pay, consumer demand for goods and services

increases. This in turn rekindles businesses and turns the cycle around from stagnant to active.

If, however, there are no reins on this process, the increase in economic productivity can cross over a

very fine line and lead to too much money in the market. This excess in supply decreases the value of

money, while pushing up prices (because of the increase in demand for consumer products). Hence,

inflation occurs.

For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not improbable,

means to reach economic goals. If not closely monitored, the line between an economy that is productive

and one that is infected by inflation can be easily blurred. (For more on economic cycles, see

Understanding Cycles - The Key To Market Timingand How Much Influence Does The Fed Have?)

And When The Economy Needs To Be Curbed

When inflation is too strong, the economy may need a slow down. In such a situation, a government can

use fiscal policy to increase taxes in order to suck money out of the economy. Fiscal policy could alsodictate a decrease in government spending and thereby decrease the money in circulation. Of course, the

possible negative effects of such a policy in the long run could be a sluggish economy and high

unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine

tune spending and taxation levels, with the goal of evening out the business cycles.

Who Does Fiscal Policy Affect?

Unfortunately, the effects of any fiscal policy are not the same on everyone. Depending on the political

orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically

the largest economic group. In times of economic decline and rising taxation, it is this same group that

may have to pay more taxes than the wealthier upper class.

Similarly, when a government decides to adjust its spending, its policy may affect only a specific group ofpeople. A decision to build a new bridge, for example, will give work and more income to hundreds of

construction workers. A decision to spend money on building a new space shuttle, on the other hand,

benefits only a small, specialized pool of experts, which would not do much to increase aggregate

employment levels.

Conclusion

One of the biggest obstacles facing policymakers is deciding how much involvement the government

should have in the economy. Indeed, there have been various degrees of interference by the government

over the years. But for the most part, it is accepted that a degree of government involvement is necessary

to sustain a vibrant economy, on which the economic well being of the population depends.

(For the latest on U.S. and global economic conditions, try the Economic Section at Forbes.com.)

2-Monetary Policy
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What Does Monetary PolicyMean?The actions of a central bank, currency board or other regulatory committee that determine the size andrate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintainedthrough actions such as increasing the interest rate, or changing the amount of money banks need tokeep in the vault (bank reserves).

Investopedia explains Monetary PolicyIn the United States, the Federal Reserve is in charge of monetary policy. The monetary policy is one ofthe ways the government attempts to control the economy. If the money supply grows too fast inflation willbe too high if it is too slow economic growth slows which affects the gross domestic product GDP. Ingeneral the US attempts to maintain a steady inflation of between 2% to 3%.

3-Abalance sheet, also known as a "statement of financial position", reveals a company'sassets,

liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cashflow statement, make up the cornerstone of any company's financial statements. If you are a shareholder

of a company, it is important that you understand how the balance sheet is structured, how to analyze it

and how to read it.

How the Balance Sheet Works

The balance sheet is divided into two parts that, based on the following equation, must equal each other,

or balance each other out. The main formula behind balance sheets is:

Assets = Liabilities + Shareholders' Equity

This means that assets, or the means used to operate the company, are balanced by a company'sfinancial obligations along with the equity investment brought into the company and its retained earnings.

Assets are what a company uses to operate its business, while its liabilities and equity are two sourcesthat support these assets. Owners' equity, referred to as shareholders' equity in a publicly tradedcompany, is the amount of money initially invested into the company plus anyretained earnings, and itrepresents a source of funding for the business.

It is important to note that a balance sheet is a snapshot of the companys financial position at a singlepoint in time. (To learn more about reading financial statements, seeWhat You Need To Know AboutFinancial Statements,What Is A Cash Flow Statement?andUnderstanding The Income Statement.)

Know the Types of Assets

Current Assets

Current assets have a life span of one year or less, meaning they can be converted easily into

cash. Such assets classes includecash and cash equivalents,accounts receivableandinventory.

Cash, the most fundamental of current assets, also includes non-restricted bank accounts and

checks. Cash equivalents are very safe assets that can be readily converted into cash; U.S.

Treasuriesare one such example. Accounts receivables consist of the short-term obligations

owed to the company by its clients. Companies often sell products or services to customers on

credit; these obligations are held in the current assets account until they are paid off by the
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clients. Lastly, inventory represents the raw materials, work-in-progress goods and the companys

finished goods. Depending on the company, the exact makeup of the inventory account will differ.

For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm

caries none. The makeup of a retailer's inventory typically consists of goods purchased from

manufacturers and wholesalers.

Non-Current Assets

Non-current assets are assets that are not turned into cash easily, are expected to be turned into

cash within a year and/or have a life-span of more than a year. They can refer to tangible assets

such as machinery, computers, buildings and land. Non-current assets also can beintangible

assets, such as goodwill,patentsor copyright. While these assets are not physical in nature, they

are often the resources that can make or break a company - the value of a brand name, for

instance, should not be underestimated.

Depreciation is calculated and deducted from most of these assets, which represents the

economic cost of the asset over its useful life.Learn the Different Liabilities

On the other side of the balance sheet are the liabilities. These are the financial obligations a companyowes to outside parties. Like assets, they can be both current and long-term. Long-term liabilitiesaredebts and other non-debt financial obligations, which are due after a period of at least one year from thedate of the balance sheet. Current liabilities are the companys liabilities which will come due, or must bepaid, within one year. This is includes both shorter term borrowings, such as accounts payables, alongwith the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan.

Shareholders' EquityShareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscalyear, a company decides to reinvest its net earnings into the company (after taxes), these retainedearnings will be transferred from the income statementonto the balance sheet into the shareholdersequity account. This account represents a company's total net worth. In order for the balance sheet tobalance, total assets on one side have to equal total liabilities plus shareholders' equity on the other.

Read the Balance SheetBelow is an example of a balance sheet:
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Source: http://www.edgar-online.com

As you can see from the balance sheet above, it is broken into two sides. Assets are on the left side and

the right side contains the companys liabilities and shareholders equity. It is also clear that this balance

sheet is in balance where the value of the assets equals the combined value of the liabilities and

shareholders equity.

Another interesting aspect of the balance sheet is how it is organized. The assets and liabilities sections

of the balance sheet are organized by how current the account is. So for the asset side, the accounts are

classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized fromshort to long-term borrowings and other obligations.

Analyze the Balance Sheet With Ratios

With a greater understanding of the balance sheet and how it is constructed, we can look now at some

techniques used to analyze the information contained within the balance sheet. The main way this is done

is through financial ratio analysis.

Financial ratio analysis uses formulas to gain insight into the company and its operations. For the balance

sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the companys

financial condition along with its operational efficiency. It is important to note that some ratios will need

information from more than one financial statement, such as from the balance sheet and the income

statement.

The main types of ratios that use information from the balance sheet are financial strength ratios and

activity ratios. Financial strength ratios, such as the working capital and debt-to-equity ratios, provide

information on how well the company can meet its obligations and how they are leveraged. This can give

investors an idea of how financially stable the company is and how the company finances itself. Activity

ratios focus mainly on current accounts to show how well the company manages its operating cycle

(which include receivables, inventory and payables). These ratios can provide insight into the company's
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operational efficiency.

There are a wide range of individual financial ratios that investors use to learn more about a company.

(To learn more about ratios and how to use them, see ourRatio Tutorial.)

Conclusion

The balance sheet, along with the income and cash flow statements, is an important tool for investors to

gain insight into a company and its operations. The balance sheet is a snapshot at a single point in time

of the companys accounts - covering its assets, liabilities and shareholders equity. The purpose of the

balance sheet is to give users an idea of the companys financial position along with displaying what the

company owns and owes. It is important that all investors know how to use, analyze and read this

document.

To read more on balance sheets, seeBreaking Down The Balance Sheet,Introduction To Fundamental

AnalysisandHow are a company's financial statements connected?

3Breaking Down The Balance Sheetby Richard Loth(Contact Author|Biography)

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A company's financial statements - balance sheet,income statement and cash flow statement- area key source of data for analyzing the investment value of its stock. Stock investors, both the do-it-yourselfers and those who follow the guidance of an investment professional, don't need to be analyticalexperts to perform financial statement analysis. Today, there are numerous sources of independent stockresearch, online and in print, which can do the "number crunching" for you. However, if you're going tobecome a serious stock investor, a basic understanding of the fundamentals of financial statement usageis a must. In this article, we help you to become more familiar with the overall structure of the balance

sheet.

The Structure of a Balance SheetA company's balance sheet is comprised ofassets, liabilities and equity. Assets represent things of valuethat a company owns and has in its possession or something that will be received and can be measuredobjectively. Liabilities are what a company owes to others - creditors, suppliers, tax authorities,employees etc. They are obligations that must be paid under certain conditions and time frames. Acompany's equity represents retained earnings and funds contributed by its shareholders, who accept the
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uncertainty that comes with ownership risk in exchange for what they hope will be a good return on theirinvestment.

The relationship of these items is expressed in the fundamental balance sheet equation:

Assets = Liabilities + Equity

The meaning of this equation is important. Generally sales growth, whether rapid or slow, dictates a largerasset base - higher levels of inventory, receivables and fixed assets (plant, property and equipment). As acompany's assets grow, its liabilities and/or equity also tends to grow in order for its financial position tostay in balance.

To learn more, check out ourbalance sheet video:

How assets are supported, or financed, by a corresponding growth in payables, debt liabilities and equityreveals a lot about a company's financial health. For now, suffice it to say that depending on a company's

line of business and industry characteristics, possessing a reasonable mix of liabilities and equity is a signof a financially healthy company. While it may be an overly simplistic view of the fundamental accountingequation, investors should view a much bigger equity value compared to liabilities as a measure ofpositive investment quality, because possessing high levels of debt can increase the likelihood that abusiness will face financial troubles.

Balance Sheet FormatsStandard accounting conventions present the balance sheet in one of two formats: the account form(horizontal presentation) and the report form (vertical presentation). Most companies favor the verticalreport form, which doesn't conform to the typical explanation in investment literature of the balance sheetas having "two sides" that balance out. (For more information on how to decipher balance sheets, seeReading The Balance Sheet.)

Whether the format is up-down or side-by-side, all balance sheets conform to a presentation that

positions the various account entries into five sections:

Assets = Liabilities + Equity

Current assets(short-term): items that are convertible into cash within one year Non-current assets (long-term): items of a more permanent nature

As total assets these =

Current liabilities (short-term): obligations due within one year Non-current liabilities (long-term): obligations due beyond one year

These total liabilities +

Shareholders' equity (permanent): shareholders' investment and retained earnings

Account PresentationIn the asset sections mentioned above, the accounts are listed in the descending order of theirliquidity(how quickly and easily they can be converted to cash). Similarly, liabilities are listed in the order of theirpriority for payment. In financial reporting, the terms currentand non-currentare synonymous with theterms short-term and long-term, respectively, and are used interchangeably. (For related reading, see
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The Working Capital Position.)

It should not be surprising that the diversity of activities included among publicly-traded companies isreflected in balance sheet account presentations. The balance sheets of utilities, banks, insurancecompanies, brokerage and investment banking firms and other specialized businesses are significantlydifferent in account presentation from those generally discussed in investment literature. In theseinstances, the investor will have to make allowances and/or defer to the experts.

Lastly, there is little standardization of account nomenclature. For example, even the balance sheet hassuch alternative names as a "statement of financial position" and "statement of condition". Balance sheetaccounts suffer from this same phenomenon. Fortunately, investors have easy access to extensivedictionaries of financial terminology to clarify an unfamiliar account entry. (To search a financial term, seeourdictionary.)

The Importance of DatesA balance sheet represents a company's financial position for one day at itsfiscal yearend, for example,the last day of its accounting period, which can differ from our more familiar calendar year. Companiestypically select an ending period that corresponds to a time when their business activities have reachedthe lowest point in their annual cycle, which is referred to as their natural business year.

In contrast, the income and cash flow statements reflect a company's operations for its whole fiscal year -365 days. Given this difference in "time", when using data from the balance sheet (akin to a photographicsnapshot) and the income/cash flow statements (akin to a movie) it is more accurate, and is the practiceof analysts, to use an average number for the balance sheet amount. This practice is referred to as"averaging", and involves taking the year-end (2004 and 2005) figures - let's say for total assets - andadding them together, and dividing the total by two. This exercise gives us a rough but usefulapproximation of a balance sheet amount for the whole year 2005, which is what the income statementnumber, let's say net income, represents. In our example, the number for total assets at year-end 2005would overstate the amount and distort the return on assetsratio (net income/total assets).

Since a company's financial statements are the basis of analyzing the investment value of a stock, thisdiscussion we have completed should provide investors with the "big picture" for developing anunderstanding of balance sheet basics.

To learn more about financial statements, readWhat You Need To Know About Financial Statements,

Understanding The Income Statementand The Essentials Of Cash Flow.

by Richard Loth(Contact Author| Biography)

Richard Loth has more than 38 years of professional experience in the financial services sector, includingbanking, investment consulting and capital markets development, both internationally and in the U.S. Hehas worked with Citibank, Fleet National Bank and the Bank of Montreal. Mr. Loth is currently themanaging principal of Mentor Investing, an independent Registered Investment Adviser based in Eagle,Colorado. Over the years, he has authored several investment education articles, publications, andbooks.

4-What You Need To Know About Financial Statements
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Knowing how to work with the numbers in a company's financial statements is an essential skill for stockinvestors. The meaningful interpretation and analysis ofbalance sheets, income statements and cashflow statementsto discern a company's investment qualities is the basis for smart investment choices.However, the diversity of financial reporting requires that we first become familiar with certain generalfinancial statement characteristics before focusing on individual corporate financials. In this article, we'llshow you what the financial statements have to offer and how to use them to your advantage.

Financial Statements are ScorecardsThere are millions of individual investors worldwide, and while a large percentage of these investors havechosen mutual fundsas the vehicle of choice for their investing activities, a very large percentage ofindividual investors are also investing directly in stocks. Prudent investing practices dictate that we seekout quality companies with strong balance sheets, solid earnings and positive cash flows.

Whether you're a do-it-yourself or rely on guidance from an investment professional, learning certainfundamental financial statement analysis skills can be very useful - it's certainly not just for the experts.Over thirty years ago, businessman Robert Follet wrote a wonderful little book entitled "How To KeepScore In Business" (1987). His principal point was that in business you keep score with dollars, and thescorecard is a financial statement. He recognized that "a lot of people don't understand keeping score inbusiness. They get mixed up about profits,assets, cash flow and return on investment."

The same thing could be said today about a large portion of the investing public, especially when it comesto identifying investment values in financial statements. But don't let this intimidate you; it can be done. AsMichael C. Thomsett says in "Mastering Fundamental Analysis" (1998):

"That there is no secret is the biggest secret of Wall Street - and of any specialized industry. Very little inthe financial world is so complex that you cannot grasp it. The fundamentals - as their name implies - arebasic and relatively uncomplicated. The only factor complicating financial information is jargon, overlycomplex statistical analysis and complex formulas that don't convey information any better than straighttalk." (For more information, see Introduction To Fundamental Analysis andWhat Are Fundamentals?)

What follows is a brief discussion of twelve common financial statement characteristics to keep in mindbefore you start your analytical journey.

What Financial Statements To UseFor investment analysis purposes, the financial statements that are used are the balance sheet, theincome statement and the cash flow statement. The statements ofshareholders' equity and retainedearnings, which are seldom presented, contain nice-to-know, but not critical, information, and are notused by financial analysts. A word of caution: there are those in the general investing public who tend tofocus on just the income statement and the balance sheet, thereby relegating cash flow considerations tosomewhat of a secondary status. That's a mistake; for now, simply make a permanent mental note thatthe cash flow statement contains critically important analytical data. (To learn more, check out ReadingThe Balance Sheet,Understanding The Income Statementand The Essentials Of Cash Flow.)
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Knowing What's Behind the NumbersThe numbers in a company's financials reflect real world events. These numbers and the financialratios/indicators that are derived from them for investment analysis are easier to understand if you canvisualize the underlying realities of this essentially quantitative information. For example, before you startcrunching numbers, have an understanding of what the company does, its products and/or services, andthe industry in which it operates.

The Diversity of Financial ReportingDon't expect financial statements to fit into a single mold. Many articles and books on financial statementanalysis take a one-size-fits-all approach. The less-experienced investor is going to get lost when he orshe encounters a presentation of accounts that falls outside the mainstream or so-called "typical"company. Simply remember that the diverse nature of business activities results in a diversity of financialstatement presentations. This is particularly true of the balance sheet; the income and cash flowstatements are less susceptible to this phenomenon.

The Challenge of Understanding Financial JargonThe lack of any appreciable standardization of financial reporting terminology complicates theunderstanding of many financial statement account entries. This circumstance can be confusing for thebeginning investor. There's little hope that things will change on this issue in the foreseeable future, but a

good financial dictionary can help considerably.

Accounting is an Art, Not a ScienceThe presentation of a company's financial position, as portrayed in its financial statements, is influencedby management estimates and judgments. In the best of circumstances, management is scrupulouslyhonest and candid, while the outside auditors are demanding, strict and uncompromising. Whatever thecase, the imprecision that can be inherently found in the accounting process means that the prudentinvestor should take an inquiring and skeptical approach toward financial statement analysis. (For relatedcontent, see Don't Forget To Read The Prospectus!andHow To Read Footnotes - Part 2: Evaluating

Accounting Risk.)

Two Key Accounting ConventionsGenerally accepted accounting principles(GAAP) are used to prepare financial statements. The sum total

of these accounting concepts and assumptions is huge. For investors, a basic understanding of at leasttwo of these conventions - historical cost and accrual accounting - is particularly important. According toGAAP, assets are valued at their purchase price (historical cost), which may be significantly different thantheir current market value. Revenues are recorded when goods or services are delivered and expensesrecorded when incurred. Generally, this flow does not coincide with the actual receipt and disbursementof cash, which is why the cash flow becomes so important.

Non-Financial Statement InformationInformation on the state of the economy, industry and competitive considerations, market forces,technological change, and the quality of management and the workforce are not directly reflected in acompany's financial statements. Investors need to recognize that financial statement insights are but onepiece, albeit an important one, of the larger investment information puzzle.

Financial Ratios and IndicatorsThe absolute numbers in financial statements are of little value for investment analysis, which musttransform these numbers into meaningful relationships to judge a company's financial performance andcondition. The resulting ratios and indicators must be viewed over extended periods to reflect trends.Here again, beware of the one-size-fits-all syndrome. Evaluative financial metrics can differ significantlyby industry, company size and stage of development.

Notes to the Financial StatementsIt is difficult for financial statement numbers to provide the disclosure required by regulatory authorities.Professional analysts universally agree that a thorough understanding of thenotes to financial statements
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is essential in order to properly evaluate a company's financial condition and performance. As noted byauditors on financial statements "the accompanying notes are an integral part of these financialstatements." Take these noted comments seriously. (For more insight, see Footnotes: Start Reading TheFine Print.)

The Auditor's ReportPrudent investors should only consider investing in companies with audited financial statements, whichare a requirement for all publicly traded companies. Before digging into a company's financials, the firstthing to do is read the auditor's report. A "clean opinion" provides you with a green light to proceed.Qualifying remarks may be benign or serious; in the case of the latter, you may not want to proceed.

Consolidated Financial StatementsGenerally, the word "consolidated" appears in the title of a financial statement, as in aconsolidatedbalance sheet. Consolidation of a parent company and its majority-owned (more that 50% ownership or"effective control") subsidiaries means that the combined activities of separate legal entities areexpressed as one economic unit. The presumption is that a consolidation as one entity is moremeaningful than separate statements for different entities.

The financial statement perspectives provided in this overview are meant to give readers the big picture.With these considerations in mind, beginning investors should be better prepared to cope with learning

the analytical details of discerning the investment qualities reflected in a company's financials.

by Richard Loth(Contact Author| Biography)

Richard Loth has more than 38 years of professional experience in the financial services sector, includingbanking, investment consulting and capital markets development, both internationally and in the U.S. Hehas worked with Citibank, Fleet National Bank and the Bank of Montreal. Mr. Loth is currently themanaging principal of Mentor Investing, an independent Registered Investment Adviser based in Eagle,Colorado. Over the years, he has authored several investment education articles, publications, andbooks.

5

How are a company's financial statements connected?

When you do research on different companies by looking at theirannual reports, you will typicallycome across two separate financial statements: thebalance sheet and the income statement (alsoknown as the statement of profit and loss). These two statements are very significant for companies

as they can be used to describe the company's health and effectiveness of management.

Balance Sheet - B/SThebalance sheet gives investors a general overview of a company's financial situation. That is, ittells investors exactly what a company owns (assets) and who it owes (liabilities).

Assets and liabilities are listed in order of liquidity (relative ease of convertibility to cash), from mostliquid to least liquid. Assets appear on the left hand side of the balance sheet and liabilities on theright hand side. For simplicity's sake, think of a B/S as an indicator ofnet worth: that is, how much acompany is worth "on the books."
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Income Statement I/SThe income statement tells investors about the company's profits and losses for a specific timeperiod. Expenses are subtracted from income to determine a firm's profit or loss. Unlike the B/S, theI/S doesn't look at the company's financial health (total net worth). Instead, it looks at how muchrevenue a company is able to create. If you were to think of the B/S as an indicator of net worth, youcan think of the I/S as a company's profitability: that is, how much it can make in a given time frame.

These two statements are intertwined and should be looked at by all people who are consideringinvesting their hard earned money in a particular company. You should look at a company's B/S tosee exactly how much it is worth (remember, this is a book value representation rather than marketcapitalization), and look at the I/S to see how profitable the company is. Obviously, if it has a negativenet worth (its liabilities are greater than its assets) or if it has a negative income, then the companymight not be the best place to invest your money.

6

Sponsor: Cook up a market-stomping portfolio with our FREE report7 Ingredients to Market BeatingStocks.

By Ben McClure

So, you want be a stock analyst? Perhaps not, but since you're reading this we'll assume that you at least want tounderstand stocks. Whether it's your burning desire to be a hotshot analyst on Wall Street or you just like to behands-on with your ownportfolio, you've come to the right spot.

Fundamental analysisis the cornerstone of investing. In fact, some would say that you aren't really investing if youaren't performing fundamental analysis.Because the subject is so broad, however, it's tough to know where to start.

There are an endless number of investment strategies that are very different from each other, yet almost all use thefundamentals.

The goal of this tutorial is to provide a foundation for understanding fundamental analysis. It's geared primarily at newinvestors who don't know abalance sheetfrom an income statement.While you may not be a "stock-pickerextraordinaire" by the end of this tutorial, you will have a much more solid grasp of the language and concepts behindsecurity analysis and be able to use this to further your knowledge in other areas without feeling totally lost.

The biggest part of fundamental analysis involves delving into the financial statements. Also known as quantitativeanalysis, this involves looking at revenue, expenses,assets,liabilitiesand all the other financial aspects of acompany. Fundamental analysts look at this information to gain insight on a company's future performance. A goodpart of this tutorial will be spent learning about the balance sheet, income statement, cash flow statementand howthey all fit together.

But there is more than just number crunching when it comes to analyzing a company. This is where qualitativeanalysis comes in - the breakdown of all the intangible, difficult-to-measure aspects of a company. Finally, we'll wrapup the tutorial with an intro on valuation and point you in the direction of additional tutorials you might be interested in.

(Also, although it's not required, you might find it helpful to read ourInvesting 101 tutorial, as well as our tutorial onStock Basics, before starting.)

Ready? Let's dive into things with our first section, What Is It?

Next: Fundamental Analysis: What Is It?
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Table of Contents

1) Fundamental Analysis: Introduction

2) Fundamental Analysis: What Is It?

3) Fundamental Analysis: Qualitative Factors - The Company

4) Fundamental Analysis: Qualitative Factors - The Industry

5) Fundamental Analysis: Introduction to Financial Statements

6) Fundamental Analysis: Other Important Sections Found in Financial Filings

7) Fundamental Analysis: The Income Statement

8) Fundamental Analysis: The Balance Sheet

9) Fundamental Analysis: The Cash Flow Statement

10) Fundamental Analysis: A Brief Introduction To Valuation

11) Fundamental Analysis: Conclusion

7By Ben McClure

In this section we are going to review the basics of fundamental analysis, examine how it can be broken down into

quantitative and qualitative factors, introduce the subject ofintrinsic valueand conclude with some of the downfalls of

using this technique.

The Very BasicsWhen talking about stocks, fundamental analysis is a technique that attempts to determine a securitys value byfocusing on underlying factors that affect a company's actualbusiness and its future prospects. On a broader scope,you can perform fundamental analysis onindustries or the economyas a whole. The term simply refers to theanalysis of the economic well-being of a financial entity as opposed to only its price movements.

Fundamental analysis serves to answer questions, such as:

Is the companys revenue growing?

Is it actually making aprofit? Is it in a strong-enough position to beat out its competitors in the future?

Is it able to repay itsdebts?

Is management trying to "cook the books"?Of course, these are very involved questions, and there are literally hundreds of others you might have about acompany. It all really boils down to one question: Is the companys stock a good investment? Think of fundamentalanalysis as a toolbox to help you answer this question.

Note: The term fundamental analysis is used most often in the context of stocks, but you can perform fundamentalanalysis on any security, from a bond to a derivative. As long as you look at the economic fundamentals, you are
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doing fundamental analysis. For the purpose of this tutorial, fundamental analysis always is referred to in the contextof stocks.

Fundamentals: Quantitative and QualitativeYou could define fundamental analysis as researching the fundamentals, but that doesnt tell you a whole lot unlessyou know what fundamentals are. As we mentioned in the introduction, the big problem with defining fundamentals isthat it can include anything related to the economic well-being of a company. Obvious items include things like

revenue and profit, but fundamentals also include everything from a companys market share to the quality of itsmanagement.

The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financialmeaning of these terms isnt all that different from their regular definitions. Here is how the MSN Encarta dictionarydefines the terms:

Quantitative capable of being measured or expressed in numerical terms.

Qualitative related to or based on the quality or character of something, often as opposed to its size or

quantity.In our context, quantitative fundamentals are numeric, measurable characteristics about a business. Its easy to seehow the biggest source of quantitative data is the financial statements. You can measure revenue, profit, assets andmore with great precision.

Turning to qualitative fundamentals, these are the less tangible factors surrounding a business - things such as the

quality of a companys board members and key executives, its brand-name recognition,patents orproprietarytechnology.

Quantitative Meets QualitativeNeither qualitative nor quantitative analysis is inherently better than the other. Instead, many analysts considerqualitative factors in conjunction with the hard, quantitative factors. Take the Coca-Cola Company, for example.When examining its stock, an analyst might look at the stocks annual dividend payout, earnings per share, P/E ratioand many other quantitative factors. However, no analysis of Coca-Cola would be complete without taking intoaccount its brand recognition. Anybody can start a company that sells sugar and water, but few companies on earthare recognized by billions of people. Its tough to put your finger on exactly what the Coke brand is worth, but you canbe sure that its an essential ingredient contributing to the companys ongoing success.

The Concept of Intrinsic ValueBefore we get any further, we have to address the subject of intrinsic value. One of the primary assumptions offundamental analysis is that the price on the stock market does not fully reflect a stocks real value. After all, why

would you be doing price analysis if the stock market were always correct? In financial jargon, this true value isknown as the intrinsic value.

For example, lets say that a companys stock was trading at $20. After doing extensive homework on the company,you determine that it really is worth $25. In other words, you determine the intrinsic value of the firm to be $25. This isclearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimatedintrinsic value.

This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market willreflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected thatvalue. Nobody knows how long the long run really is. It could be days or years.

This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate theintrinsic value of a firm and thus find opportunities where he or she can buy at a discount. If all goes well, theinvestment will pay off over time as the market catches up to the fundamentals.

The big unknowns are:

1)You dont know if your estimate of intrinsic value is correct; and2)You dont know how long it will take for the intrinsic value to be reflected in the marketplace.

Criticisms of Fundamental AnalysisThe biggest criticisms of fundamental analysis come primarily from two groups: proponents oftechnical analysis andbelievers of the efficient market hypothesis.
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Technical analysis is the other major form of security analysis. Were not going to get into too much detail on thesubject. (More information is available in ourIntroduction to Technical Analysis tutorial.)

Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volumemovements of securities. Using charts and a number of other tools, they trade on momentum, not caring about the

fundamentals. While it is possible to use both techniques in combination, one of the basic tenets of technical analysisis that the market discounts everything. Accordingly, all news about a company already is priced into a stock, andtherefore a stocks price movements give more insight than the underlying fundamental factors of the business itself.

Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental andtechnical analysts. The efficient market hypothesis contends that it is essentially impossible to produce market-beating returns in the long run, through either fundamental or technical analysis. The rationale for this argument isthat, since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns derivedfrom fundamental (or technical) analysis would be almost immediately whittled away by the markets manyparticipants, making it impossible for anyone to meaningfully outperform the market over the long term.

Next: Fundamental Analysis: Qualitative Factors - The Company

Table of Contents

1) Fundamental Analysis: Introduction

2) Fundamental Analysis: What Is It?

3) Fundamental Analysis: Qualitative Factors - The Company

4) Fundamental Analysis: Qualitative Factors - The Industry

5) Fundamental Analysis: Introduction to Financial Statements

6) Fundamental Analysis: Other Important Sections Found in Financial Filings

7) Fundamental Analysis: The Income Statement

8) Fundamental Analysis: The Balance Sheet

9) Fundamental Analysis: The Cash Flow Statement

10) Fundamental Analysis: A Brief Introduction To Valuation11) Fundamental Analysis: Conclusion

8

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By Ben McClure

Before diving into a company's financial statements, we're going to take a look at some of thequalitative aspects of acompany.

Fundamental analysis seeks to determine the intrinsic value of a company's stock. But since qualitative factors, bydefinition, represent aspects of a company's business that are difficult or impossible to quantify, incorporating thatkind of information into a pricing evaluation can be quite difficult. On the flip side, as we've demonstrated, you can'tignore the less tangible characteristics of a company.
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In this section we are going to highlight some of the company-specific qualitative factors that you should be aware of.

Business ModelEven before an investor looks at a company's financial statements or does any research, one of the most importantquestions that should be asked is: What exactly does the company do? This is referred to as a company's businessmodel it's how a company makes money. You can get a good overview of a company's business modelby

checking out its website or reading the first part of its 10-K filing(Note: We'll get into more detail about the 10-K in thefinancial statements chapter. For now, just bear with us).

Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries,soft drinks, salads and whatever other new special they are promoting at the time. It's a simple model, easy enoughfor anybody to understand.

Other times, you'd be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back inthe early '90s its stock was the darling of Wall Street. At one point the company's CEO bragged that they were the"first new fast-food restaurant to reach $1 billion in sales since 1969". The problem is, they didn't make money byselling chicken. Rather, they made their money from royalty fees and high-interest loans to franchisees. BostonChicken was really nothing more than a big franchisor. On top of this, management was aggressive with how itrecognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cardscollapsed and the company went bankrupt.

At the very least, you should understand the business model of any company you invest in. The "Oracle of Omaha",Warren Buffett, rarely invests in tech stocks because most of the time he doesn't understand them. This is not to saythe technology sector is bad, but it's not Buffett's area of expertise; he doesn't feel comfortable investing in this area.Similarly, unless you understand a company's business model, you don't know what the drivers are for future growth,and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.

Competitive AdvantageAnother business consideration for investors is competitive advantage. A company's long-term success is drivenlargely by its ability to maintain a competitive advantage - and keep it. Powerful competitive advantages, such asCoca Cola's brand name and Microsoft's domination of the personal computer operating system, create amoataround a business allowing it to keep competitors at bay and enjoy growth and profits. When a company can achievecompetitive advantage, its shareholders can be well rewarded for decades.

Harvard Business School professorMichael Porter,distinguishes between strategic positioning and operationaleffectiveness. Operational effectiveness means a company isbetter than rivals at similar activities while competitiveadvantage means a company is performing better than rivalsby doing different activities or performing similar activities indifferent ways. Investors should know that few companies areable to compete successfully for long if they are doing thesame things as their competitors.

Professor Porter argues that, in general, sustainablecompetitive advantage gained by:

A unique competitive position Clear tradeoffs and choices vis--vis competitors

Activities tailored to the company's strategy

A high degree of fit across activities (it is the activity

system, not the parts, that ensure sustainability)

A high degree of operational effectiveness

Management
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Just as an army needs a general to lead it to victory, a company relies upon management to steer it towards financialsuccess. Some believe that management is the most important aspect for investing in a company. It makes sense -even the best business model is doomed if the leaders of the company fail to properly execute the plan.

So how does an average investor go about evaluating the management of a company?

This is one of the areas in which individuals are truly at a disadvantage compared to professional investors. You can't

set up a meeting with management if you want to invest a few thousand dollars. On the other hand, if you are a fundmanager interested in investing millions of dollars, there is a good chance you can schedule a face-to-face meetingwith the upper brass of the firm.

Everypublic company has a corporate information section on its website. Usually there will be a quick biography oneach executive with their employment history, educational background and any applicable achievements. Don'texpect to find anything useful here. Let's be honest: We're looking for dirt, and no company is going to put negativeinformation on its corporate website.

Instead, here are a few ways for you to get a feel for management:

1. Conference CallsThe Chief Executive Officer(CEO) andChief Financial Officer(CFO) host quarterly conference calls. (Sometimesyou'll get other executives as well.) The first portion of the call is management basically reading off the financialresults. What is really interesting is the question-and-answer portion of the call. This is when the line is open for

analysts to call in and ask management direct questions. Answers here can be revealing about the company, butmore importantly, listen for candor. Do they avoid questions, like politicians, or do they provide forthright answers?

2. Management Discussion and Analysis (MD&A)The Management Discussion and Analysis is found at the beginning of the annual report (discussed in more detaillater in this tutorial). In theory, the MD&A is supposed to be frank commentary on the management's outlook.Sometimes the content is worthwhile, other times it'sboilerplate. One tip is to compare what management said inpast years with what they are saying now. Is it the same material rehashed? Have strategies actually beenimplemented? If possible, sit down and read the last five years of MD&As; it can be illuminating.

3. Ownership and Insider SalesJust about any large company will compensate executives with a combination of cash, restricted stock and options.While there are problems with stock options (SeePutting Management Under the Microscope), it is a positive signthat members of management are also shareholders. The ideal situation is when the founder of the company is still incharge. Examples include Bill Gates (in the '80s and '90s), Michael Dell and Warren Buffett. When you know that a

majority of management's wealth is in the stock, you can have confidence that they will do the right thing. As well, it'sworth checking out if management has been selling its stock. This has to be filed with theSecurities and ExchangeCommission(SEC), so it's publicly available information. Talk is cheap - think twice if you see management unloadingall of its shares while saying something else in the media.

4. Past PerformanceAnother good way to get a feel for management capability is to check and see how executives have done at othercompanies in the past. You can normally find biographies of top executives on company web sites. Identify thecompanies they worked at in the past and do a search on those companies and their performance.

Corporate GovernanceCorporate governance describes the policies in place within an organization denoting the relationships andresponsibilities between management, directors andstakeholders. These policies are defined and determined in thecompany charterand its bylaws, along with corporate laws and regulations. The purpose of corporate governancepolicies is to ensure that proper checks and balances are in place, making it more difficult for anyone to conductunethical and illegal activities.

Good corporate governance is a situation in which a company complies with all of its governance policies andapplicable government regulations (such as theSarbanes-Oxley Act of 2002) in order to look out for the interests ofthe company's investors and other stakeholders.

Although, there are companies and organizations (such asStandard & Poor's) that attempt toquantitatively assesscompanies on how well their corporate governance policies serve stakeholders, most of these reports are quite
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expensive for the average investor to purchase.

Fortunately, corporate governance policies typically cover a few general areas: structure of the board of directors,stakeholder rights and financial and information transparency. With a little research and the right questions in mind,investors can get a good idea about a company's corporate governance.

Financial and Information Transparency

This aspect of governance relates to the quality and timeliness of a company's financial disclosures and operationalhappenings. Sufficient transparency implies that a company's financial releases are written in a manner thatstakeholders can follow what management is doing and therefore have a clear understanding of the company'scurrent financial situation.

Stakeholder RightsThis aspect of corporate governance examines the extent that a company's policies are benefiting stakeholderinterests, notably shareholder interests. Ultimately, as owners of the c

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