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Chapter 7.1

Fundamental Analysis Explained

When you invest into stock markets choosing the stocks correctly is very important because performance of these stocks will decide the returns you will get on your investments.

# 1. Fundamental analysis

Fundamental Analysis is an approach to study a business. When an investor wishes to invest in a business for 3-5 years (long term) it becomes essential to understand the business or company from various angles. It is significant for an investor to disconnect with the daily noise in the stock prices and focus on the underlying business of the company. Over a long term, the stock prices of a fundamentally strong company tend to increase, thereby giving good returns & creating wealth for its investors. E.g. Marico Ltd. which manufactures parachute hair oil was a company trading at Rs.27 in 2007 and today in 2016 its price is Rs.250 i.e. it has given around 10 times returns in less than 10 years. So the magnitude of wealth created if a fundamentally strong stock is selected is huge.

E.g. Marico Ltd. which manufactures parachute hair oil was a company trading at Rs.27 in 2007 and today in 2016 its price is Rs.250 i.e. it has given around 10 times returns in less than 10 years. So the magnitude of wealth created if a fundamentally strong stock is selected is huge

Fundamental analysis takes into account factors such as economic analysis, industry analysis, company analysis etc. to predict company’s future performace. Under fundamental analysis we try and identify companies with Quality governance & strong financials which will generate higher returns for investors in the future. A fundamental analyst has to Understand businesses with respect to the industry in which it operates & Understanding the basic financial statements.

Economic analysis: Before an investor invests in a company he has to learn about the economy in which the company is functional. Economic analysis is important because if the economy does not function well it will have the implications on the company too. In economic analysis various economic indicators like GDP, interest rates, IIP numbers, BOP numbers; unemployment rate is studied to assess the position of the economy.

Economic analysis gives understanding whether the economy provides opportunity for the companies to grow. Eg.Indian Economy provides opportunity for growth, higher business confidence & increasing incomes so it is conducive for growth. So an investor who wishes to invest his money in a particular company functioning in India will get a confidence from the economic perspective.

Industry analysis: Industry analysis is to analyze the position of industry in an economy & how a company is positioned in that particular industry. The purpose of industry analysis is to identify those industries with a potential for future growth and to invest in equity shares of companies selected from such industries. Here we check how many players are present in the industry, what are the government policies that are in the favor of the industry, how the demand supply structure in the industry is & what are the alternatives that can eat up into the market share of that particular industry. We look at the product lifecycle phase and competitive outlook in a particular industry to gauge the overall growth and competitive rivalry amongst the players in the industry.

Company Analysis: Every company has its own characteristics. Here we take a look at the quality of management of the company. How has been the management’s performance been in the past. We check the competitive standing of the company, whether the company has some advantage which the other competitors might not have, what is the market share of the company etc.We majorly look at the qualitative aspect of the company here the promoter share holding pattern, management qualification & performance.

Financial Statement Analysis

In financial analysis we analyze whether the company has steady earnings, cash to run its business in future & potential to increase its profits. This analysis is done by analyzing different financial statements which the company publishes. These statements are available in the company’s annual report which is generally available on the company site. The annual report also consist the details about the management which will help in quality analysis of the company. It also consist of management discussion on future strategy the management will be using for growth. Financial analysis involves studying the companies past financial performance and estimating its future performance.

The different types of financial statements give the information about the income, expenses, assets, liabilities & cash available in the company. Different types of financial statements are Balance sheet, Profit & Loss & cash flow statement. We can get these statements from the annual reports of the company which is uploaded on the company website or the stock exchange website.

Balance sheet Statement

Balance sheet is a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time in the calendar year. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders in the company.

Balance sheet has two sides Asset & Liability side. Asset side consists of noncurrent assets which includes assets which give benefits for more than 365 days. The tangible assets are called fixed assets and accumulated depreciation is subtracted from it to arrive at Net Fixed assets. (Accumulated depreciation i.e the P&L depreciation cost added up year on Year for that particular asset).

Asset side also consists of intangible assets like patent, license etc. Noncurrent assets also include capital work in progress which accounts for any building under construction, machinery under assembly etc at the time of preparing the balance sheet. Other items in the noncurrent assets are investment, long term loans & advances (to subsidiaries, employees, tax authorities).

2nd major category on the asset side is current asset and it includes the assets whose benefits have longevity of less than 365 days. It includes Inventory (value of the stock of finished goods to be sold), Trade receivable (i.e. credit sales - the amount which is due from the buyers), Cash & cash equivalent, Short-term loans & advances. So the total asset of the company is noncurrent assets +current assets.

The other part of balance sheet is the liability side and it consists

Shareholders funds: It is share capital plus reserves & surplus. Share capital = face value of a share *no of shares outstanding of the company. Reserves is the money allocated by the company for future capital expenses or profits to be distributed to the shareholders etc. & Surplus is the Profit that the company has earned in this financial year (PAT from P&L)

2nd item on liability side is non current liabilities. These are the liabilities which the company is suppose to pay after 365 days. It includes long term borrowings from bank & other sources. Deferred Tax liability (Tax which the company is suppose to pay) & Long term provisions (this is the amount set aside for employee benefits such as gratuity; leave encashment, provident funds etc.)

3rd category of liability is current liabilities: These are the liabilities to be paid within 365 days. This category includes short term borrowings, Trade payables (If the company has purchased raw material on credit then the amount due to supplier is trade payables), Other current liabilities (Other current Liabilities’ are obligations associated with the statutory requirements and obligations that are not directly related to the operations of the company) & short term provisions(this is the amount set aside for employee benefits such as gratuity; leave encashment, provident funds etc. for a short term duration).

Thus liabilities=shareholders funds + noncurrent liabilities+ current liabilities.
The Asset side of balance sheet is always equal to the liability side.

Profit & Loss statement
Profit & Loss is a financial statement that reviews the company’s earnings and its expenses incurred during a specific period of time, usually a financial quarter or a year. This statement reflects the company’s ability to generate earnings and control its cost by improving its efficiency.

The P&L statement reports information on:

1. The revenue of the company for the given period (yearly or quarterly) it is also called the top line of the company or simply total sales of the product or services sold by the company in the given period of time. Revenue of a company also has other operating income  component which generated by the sale products or services that are incidental to the core operations of the company. Eg. A battery company revenue includes its direct battery sales plus its maintenance services income & also sale of scrap as other operating income.

2. The expenses incurred to generate the revenues. These expenses include Cost of manufacturing the goods sold by the company which include raw material cost, purchase of finished goods to manufacture the final product. Expenses also include employee salaries & pensions called employee benefit expenses. It also include the financial cost which is the interest paid on the debts or liabilities taken by the company.

3. Depreciation & Tax: To understand the depreciation expense lets consider a machine bought by the company at Rs.65000. The expense is once but the  benefit of the machine is for life time of the machine (which is say 5 years). This expense is accounted by spreading the expense over the life time of the machine so each year we will account depreciation expense as (65000/5) =Rs.13000 for 5 years. Tax expense is the corporate tax the company pays.

4. The earnings per share is calculated by dividing profit after tax by no. of outstanding shares of the company.
PAT / No. Of shares= 100,000,000 / 10,000,000 = Rs. 10

This earning per share gives an indication about the return which the share holders get from the profits generated by the company.

Cash flow statement: 

So cash flow statement provides data regarding all the cash inflows a company receives from its operations, investment as well as all cash outflow that pays for expenses of business activities & investments made during a specific period. Let’s understand the need of cash flow through an example. Eg. A shop sales only 1 type of computer at a standard fixed rate of Rs.25,000/- per computer. Assume on a certain day, the shop manages to sell 20 such laptops. So the revenue for the shop would be Rs.25,000 x 20 = Rs.500,000/-. But if 5 of the 20 laptops were sold on credit customer takes the product but pays the cash at a later point in time. In this situation here is how the numbers would look:

Cash sale: 15 * 25000 = Rs.375,000/-
Credit sale: 5 * 25000 = Rs.125,000/-
Total sales: Rs.500,000/-

If this shop was to show its total revenue in its P&L statement, you would just see a revenue of Rs.500,000/- which seems good on the face of it. But, how much of this Rs.500,000/- is actually present in the company’s bank account is not clear; if this company had a loan of Rs.400,000/- that had to be repaid back urgently even though the company has a sale of Rs.500,000 it has only Rs.375,000/- in its account. This means the company has a cash crunch, as it cannot meet its debt obligations. The cash flow statement captures this information.

Cash flow statement consist of three categories cash flow from operating activities, cash flow from investment activities & cash flow from financial activities. Typical operating activities include marketing, sales, technology upgrade, manufacturing, resource hiring etc. These are the daily course activities of the business. Cash movement related to these activities is recorded in cash flow from operating activities category.

Investing activities include investing money in plant and equipment, interest bearing instruments, investing in land, investing in equity shares, property, intangibles etc.

Eg.If a company purchases a new equipment then the amount spent on the purchase is subtracted from the investment cash of the company and added as an asset in the fixed asset of the balance sheet.

Financial activities include paying interest to service debt, distributing dividends, issuing corporate bonds, raising fresh debt, etc

Eg. If a company takes loan than this is cash inflow to the financial cash flow of the company and the same debt taken will be added on the liability side of the balance sheet cause the needs to be paid after a certain period of time.

So total cash =Net cash flow from operating activites+Net cash flow from investing activities + net cash flow from financial activities.

Also the cash & balance of the previous year’s cash flow is added to the present years cash flow So whenever liabilities of the company increase the cash balance also increases & vice versa. Whenever the asset of the company increases, the cash balance decreases & vice versa.

Key Takeaways:

  • While selecting a stock to invest we must first consider whether the current economic situation is positive for the industry and whether the company/stock selected for investment is a strong and leading player in the Industry
  • Detailed Financial Statement Analysis helps Investor to understand in depth the overall financial health of the company.

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