Chapter 4 Introduction to Fundamental Analysis
Fundamental Analysis (FA) is a comprehensive study of a business. When an investor wants to invest in a business for the long term (3-5 years), it is important to understand the business from various perspectives. Fundamental analysis examines economic, financial, qualitative and quantitative factors associated with a stock. It also studies the economic data, performance of its peers, company’s financial statements etc.
Interpreting financial statements
Interpreting financial statements is critical to understand the financial health of a company. The three major financial statements are the Profit & Loss Account (P&L), Balance Sheet and Cash Flow statement.
P&L Account
P&L account reflects the operating performance of the company in a given year. The operating performance shows the company’s income, expense, and hence its profitability can be derived from this statement. P&L accounts are mandatory for every company and are released every quarter.
How it looks like?
Proforma of Profit and Loss Account (P&L)
| Particulars | Year End |
|---|---|
| Sales (A) | xxx |
| EXPENDITURE : | xxx |
| Raw Material Consumed | xxx |
| Power & Fuel Cost | xxx |
| Employee Cost | xxx |
| General and Administration Expenses | xxx |
| Selling and Distribution Expenses | xxx |
| Depreciation | xxx |
| Total Expenditure (B) | xxx |
| EXPENDITURE : | xxx |
| EXPENDITURE : | xxx |
| EBIT (A-B) | xxx |
| Other Income | xxx |
| Finance Cost | xxx |
| EBIT (A-B) | xxx |
| EBT( EBIT + other Income- Finance Cost) (C) | xxx |
| Provision for Tax | xxx |
| PAT | xxx |
| Paid up Equity Capital (Face Value Rs 10) | xxx |
| EPS | xxx |
Revenue from Sale
This is the total value of items sold by the company. Revenue is recognized when an item is shipped and not necessarily when cash is received in lieu of the item.
Other Income
Any other form of income of the company including interest income on the cash that it holds in banks, investment returns on mutual funds, dividend income from subsidiaries etc are recorded here.
Cost of Goods Sold
The cost of all materials consumed and of the employees involved in manufacturing in order to produce the goods that were sold during the period.
Sales, General and Administrative Expenses
These include cost of maintenance of plant and equipment, cost of maintaining head office and regional offices, employee costs, marketing and advertising expenses etc.
Other Expenses
These include transportation costs, power and fuel, loss on foreign currency movements, impairment losses on assets and businesses, restructuring charges like cost of laying off workers etc.
Earnings before Interest, Tax, Depreciation and Amortization (EBITDA)
This is the best measure of the profitability of the company’s operations. This is the best approximation of the surplus cash generated by the business before the debt holders are paid their interest and taxes are paid to government.
Depreciation & Amortization
When a business purchases plant, equipment, machines that it intends to use over a long period of time, it does not show the expenses in one period only. Rather it spreads out the cost over the life of such equipment and show the annual cost in each year’s P&L. This is called depreciation. It is not a cash expense in the period in which it is recognized in the P&L. Amortization is similar to depreciation in concept but refers to intangible assets like cost of advertising and brand acquisition costs.
Earnings before Interest and Tax (EBIT)
This is earnings before interest due to debt holders and taxes if any on the profits.
Finance Cost
This is the interest payment on money that the company has borrowed.
Earnings before Tax (EBT)
Company pays tax to the government at the applicable tax rate on its earnings.
Profit before Tax (PBT)
This is the company’s tax liability if company has made a profit at EBT level.
Profit after Tax (PAT)
This is the company’s tax liability if company has made a profit at EBT level.
Earnings per Share (EPS)
This is the PAT divided by the number of shares issued by the company. This is the profit made per share that accrues to the share/stock holder.
Balance Sheet
Balance Sheet is a summary of what a company owns and what it owes to external parties. In other words, it shows what are the sources of its funds or liabilities (stock, debt, accumulated profits) and what uses have these funds been put to (assets created). In short, it is a statement of assets and liabilities.
How it looks like?
Proforma of Balance Sheet
| Particulars | Year End |
|---|---|
| LIABILITIES | |
| Share Capital | xxx |
| Reserves and Surplus | xxx |
| Total Reserves | xxx |
| Shareholder's Funds (A) | xxx |
| Long Term Liabilities | xxx |
| Long-Term Borrowings | xxx |
| Short Term Borrowings | xxx |
| Total Long term Liabilities (B) | xxx |
| Current Liabilities | xxx |
| Trade Payables | xxx |
| Short Term Borrowings | xxx |
| Other Current Liabilities | xxx |
| Total Current Liabilities (C) | xxx |
| Total Liabilities (A+B+C) | xxx |
| ASSETS | xxx |
| Long Term Assets | xxx |
| Plant & Machinery | xxx |
| Goodwill | xxx |
| Total Long Term Assets (D) | |
| Non Current Investments | |
| Long Term Loans & Advances | xxx |
| Total Non-Current Assets (E) | xxx |
| Current Assets Loans & Advances | xxx |
| Current Assets Loans & Advances | xxx |
| Currents Investments | xxx |
| Inventories | xxx |
| Cash and Bank | xxx |
| Short Term Loans and Advances | xxx |
| Total Current Assets (F) | xxx |
| Total Assets (D+E+F) | xxx |
Liabilities and Assets side must balance
The Asset and Liability sides of the balance sheet must balance i.e. Assets = Liabilities always.
Liabilities
Shareholder Funds/Stocks
This represents the value of the holding of stock/shareholders in the company from an accounting point of view. It is also referred to as Net worth or Net Book Value. This is the sum of paid-up capital and retained earnings. Paid-up capital is the value of shares bought by shareholders in primary sale. Retained earnings are the cumulative profits made by the company since inception less the dividends paid since inception.
Long term debt
Long term debt is the borrowings that the company owes for a period exceeding one year or more.
Short term debt
Short term debt is the debt incurred by a company that is due within one year.
Trade Payables
These are purchases that a company is yet to pay in cash to its suppliers. A higher amount is better as it reflects the company’s credibility to get longer credit period from its suppliers.
Other Current Liabilities
These include the portion of long term debt that is due for repayment in the next year, advances from customers for goods/services that the company has to provide in future and payments due to suppliers for plant, property and equipments.
Assets
Long term assets
These include property, plants and equipments, furniture and fixtures, software packages, vehicles, aircrafts etc. that the company owns for its business. It also includes plants and equipments under construction (capital work in progress) and intangible assets like brands etc.
Non-current investments
These are investments in stocks/shares of subsidiary and associate companies. Subsidiaries are companies where the publicly listed company has > 50% economic stake while associates are companies where it has < 50% economic stake.
Long term loans and advances
These are loans given to subsidiaries and associates to help them fund their assets.
Cash
This includes cash and investments in liquid funds that can be immediately converted into cash.
Current Investments
These include cash invested in instruments with less than one year maturity which can be easily sold to raise cash.
Trade Receivables
This represents value of items that the company has sold but not received payment for.
Inventories
These include raw materials that the company uses to produce the final product, semi-finished product and finished products waiting to be sold. Lower the amount the better, indicating efficient procurement strategy and no risk of obsolescence of its products.
Short term loans and advances
These are loans given to subsidiaries and associates that are due to be repaid in less than one year.
Other Current Assets
These include interest and dividend due to be received within the next one year.
Cash Flow Statement
This gives a summary of how much cash came into the company in a specific period and how much the company has spent in the same period.
| Particulars | Year End |
|---|---|
| Profit Before Tax | xxx |
| Changes In working Capital | xxx |
| Interest Paid | xxx |
| Tax Paid | xxx |
| Cash From Operating Activities (A) | xxx |
| Purchase of Plant | xxx |
| Short Term Borrowings | xxx |
| Total Long term Liabilities (B) | xxx |
| Cash Flow from Investing Activities (B) | xxx |
| Dividend Paid | |
| Cash from Financing Activities (C) | |
| Net Cash Inflow / Outflow | xxx |
| Total Current Liabilities (C) | xxx |
| Free Cash Flow (FCFF) [Operating Cash Flow- Capex] | xxx |
Cash from Operating Activities
This represents the net of all cash inflows and outflows as a result of selling the company’s products in the market. This is arrived at by adding non-cash expenses like depreciation and amortization to the company’s PAT and then adjusting for changes in current assets and current liabilities over the period of the cash flow statement. If current assets increase, cash flows decrease and vice versa. If current liabilities increase, cash flows increase and vice versa.
Operating cash flow= PAT + D&A -/+ Change in Current Assets +/- Change in Current Liabilities
Cash from Investing Activities
These include cash spent on acquisition of property, plant and equipment, or acquisition of business. It also includes surplus cash that the company invests and redeems from liquid funds.
Cash from Financing Activities
These include any cash generated from selling of stock/shares to existing or new shareholders, any addition of debt, any repayments, and dividend payments.
Free cash flow to Equity (FCFE)
This is the cash available to stock/shareholders after meeting all expenses and debt related obligations. This is the most important metric to understand the health of the business. This is calculated as:
FCFE= PAT + Depreciation – Capital Expenditure –/+ Change in current assets +/- Change in current liabilities.
Free cash flow to the company (FCFF)
This includes the cash flow available to the equity holders and debt holders in the company. This is calculated as:
FCFF= EBIT * (1 – tax rate) + Depreciation – Capital Expenditure –/+ Change in current assets +/- Change in current liabilities.
Key Takeaways
Fundamental Analysis (FA) is a comprehensive study of a business. It examines the economic, financial and qualitative factors related to a stock/ business.
P&L account reflects the operating performance of the company in a given year.
Balance sheet gives a summary of what a company owns and what it owes to external parties.
Cash flow statement gives a summary of how much cash came into the company in a specific period and how much the company spent in the same period