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# 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
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
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.

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.

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