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  1. Beginner Trading Fundamentals: Introduction
  2. Beginning Trader Fundamentals: What is Fundamental Analysis?
  3. Fundamental Analysis: Quantitative
  4. Fundamental Analysis: Qualitative
  5. Beginner Trading Fundamentals: Charting
  6. Beginner Trading Fundamentals: Leverage And Margin
  7. Beginner Trading Fundamentals: Popular Trading Instruments
  8. Beginner Trading Fundamentals: Limiting Risk
  9. Beginner Trading Fundamentals: Strategy Automation
  10. Beginner Trading Fundamentals: Record Keeping And Taxes
  11. Beginner Trading Fundamentals: Conclusion

Fundamental Analysis: Introduction to Financial Statements

 

New investors (and experienced ones as well) often find a company’s financial statements to be overwhelming. There are many different numbers and variables to account for. However, if you know how to analyze these statements, they can be a huge source of helpful information while you prepare your fundamental analysis.

 

Put simply, financial statements are the means by which a company relays information about its financial performance to the outside world. Before looking to some of the most important financial statements (income statements, balance sheets, and cash flow statements), we’ll take a moment to introduce each of them briefly and to explain what they do for a company and where to find them.

 

The Major Statements

The Balance Sheet

First, the balance sheet. A company’s balance sheet is a record of all of its assets, liabilities, and equity. It is a snapshot that shows a company’s status at a particular point in time. It is called a balance sheet because any business’s financial structure is “balanced” in this way:

 

Assets = Liabilities + Shareholders’ Equity

 

In this equation, assets stand for the resources under the company’s control at a given point in time. Assets may include a variety of items, such as cash holdings, inventory, equipment, real estate, and more. On the opposite side of the equation are the sources of financing that the company has used to acquire those assets. Liabilities represent debt which must be repaid at some point in the future and is opposed to equity, which stands for the total value of money that the company owners have contributed to the company itself. Equity includes retained earnings, or the company’s profit from previously in its history.

 

The Income Statement

The next source of data commonly used in fundamental analysis is the income statement. This statement tracks a company’s financial performance for a given period of time. To measure the performance, the income statement summarizes how that company incurs both revenues and expenses via operating and non-operating activities. Further, the income statement shows the net loss or profit that the company incurred for that given period of time. Most often, income statements track a fiscal quarter or year. Each of these components is helpful in providing an analyst with a complete picture of the health of the company.

 

Cash Flow Statement

The third critical tool for the quantitative aspect of fundamental analysis is the cash flow statement. This statement reveals how much cash comes in and goes out of a particular company, either over a quarter or for a year’s time. This may seem to be very similar to the income statement, but there are crucial differences between the two. Often, a cash flow statement focuses on these activities:

 

            1. Operating Cash Flow (OCF): this represents the cash generated from daily business

operations

            2. Cash from investing (CFI): this represents cash that is used for investing in assets, plus

the proceeds from the sale of businesses, equipment, or other assets

            3. Cash from financing (CFF): this represents cash either paid or received from issuing or

borrowing funds.

 

10-K and 10-Q

With a basic understanding of three most important financial statements, we can now consider where an investor can go about finding them. For U.S. investors, the Secuities and Exchange Commission (SEC) requires all companies which are publicly traded on a major exchange to periodically submit filings relating to their financial activities. These include the statements mentioned above, as well as additional items like an auditor’s report, management discussion and analysis (MD&A), and a detailed description of a company’s operations and prospects for the year to come.

 

All of this information is available in a company’s annual 10-K and quarterly 10-Q filings. These can be found online or in physical form; for more information about tracking down these filings, visit Where can I find a company’s annual report and its SEC filings?)

 

The 10-K filing is submitted annually and details a company’s performance across the fiscal year. This is separate from a company’s annual report, although they are sometimes both referred to as a 10-K. The annual report covers much of the same information, but it is provided in a more glamorous marketing format and is designed for investors, shareholders, and other members of the public. The 10-K itself tends to be plain and somewhat boring—it is page after page of numbers and text, including a lot of legal writing. Nonetheless, it includes a huge amount of helpful data and information.

 

10-Q filings, on the other hand, are somewhat like mini versions of the 10-K. They are released each quarter and detail a company’s performance for the previous quarter. Three 10-Q filings are released each year, corresponding to each of the first three quarters. There is no 10-Q for the fourth quarter, as that’s when the 10-K is submitted. 10-Q filings are not required to be audited, while 10-K filings are.

 

Fundamental Analysis: Other Important Sections Found in Financial Filings

 

The balance sheet, income statement, and cash flow statement of a company reveal a great deal about that company’s fundamentals: how successful it is at bringing in cash, where its expenses are focused, its ability to maintain its operations and to grow. Armed with these three documents, a potential investor is able to learn a great deal about the company and come closer to determining whether a stock is priced accurately or susceptible to a shift. When it comes to fundamental analysis, though, it is always best to consider as many factors as possible. For that reason, there are several other items which can be found in a company’s financial filings and which contribute to the larger picture of that company’s performance and health.

 

Management Discussion and Analysis (MD&A)

 

MD&A refers to the written material provided by a company’s management as a preface to the other material of the financial statements. This document is not required, but most companies include it nonetheless, as it is an opportunity for the management to discuss the past quarter or year and to provide some contextual background on the company.

 

Analysts should bear in mind what can be gleaned from the MD&A. Managers are not likely to reveal many details about their company’s performance in this section, nor are they likely to go into great lengths to discuss their company’s shortcomings. However, they can (and typically do) offer a sense of what the company’s goals are, as well as the areas in which the company has stood out for the time period in question.

 

Fundamental analysts may wish to look at MD&A statements to see what the management’s tone is, or how thoroughly the managers take into account their competition or broader financial trends.

 

Auditor’s Report

 

An auditor is an external body which is unaffiliated with the company and whose job it is to determine whether the financial statements are reasonably accurate and properly complete. The auditor will present its findings in the auditor’s report, also known as the “report of independent accountants” in some cases. Companies are required by law to have a certified public accountants firm review their annual reports to certify that there is nothing which might be misleading.

 

For the purposes of fundamental analysis, the auditor’s report is a check against potential dishonesty (or accidental miscalculation) on the part of the company’s representatives. Look to the report for a sense of how the company applied the generally accepted accounting principles (GAAP) and to determine the auditor’s opinion on the accuracy of the financial statements. It’s important to keep in mind, though, that the auditor’s report is an opinion and does not guarantee accuracy in the report. Also, most quarterly statements do not have an auditor’s report, so do not be alarmed when you don’t find one. On the other hand, any annual financials which do not have a report to accompany them should be immediately suspect, unless the company is an unlisted firm.

 

Notes to the Financial Statements

 

The third filing to keep an eye out for consists of any notes at the end of the financial statements for a company. Sometimes referred to as footnotes, these offer a summary of the overall picture of the company’s quarter or year. The footnotes often include information not found elsewhere in the company’s statements or ledgers. Look to this part of the statement for lists of outstanding leases, detailed information on the maturity of outstanding debts, summaries of compensation plans, and more.

 

Footnotes are typically divided into two categories. The first details accounting policies of the company. Pay particular attention when companies change accounting policies: some analysts believe that companies which change accounting practices too often are doing so to attempt to hide poor performance.

 

The other type of footnote is one that offers additional disclosure which could not be easily placed in the financial statements.

 

Looking to these other documents may take additional time, but remember that fundamental analysis is all about the amount of information you have and how you use it. Anything that can place you at an advantage over another competitor who is doing similar research may result in a larger profit in the future.

 

Fundamental Analysis: The Income Statement

 

One of the most important parts of an annual or quarterly report for a company is the income statement. It’s also likely the first financial statement that you’ll come across in these reports. This statement tracks a company’s financial performance for a given period of time. To measure the performance, the income statement summarizes how that company incurs both revenues and expenses via operating and non-operating activities. Further, the income statement shows the net loss or profit that the company incurred for that given period of time. Most often, income statements track a fiscal quarter or year. Each of these components is helpful in providing an analyst with a complete picture of the health of the company.

 

There are two major parts to any income statement: operating items and non-operating items. Operating items concern revenues and expenses that come about as a direct result of the company’s regular business operations. A basic example would be as follows: the operating items for a company that creates and sells candy would be those revenues and expenses related to the manufacturing of candy.

 

Non-operating items deal with revenue and expenses concerning activities that are not directly linked to the company’s regular operations. The candy store from the previous paragraph may have non-operating item expenses and revenue as well. For instance, if that company sold off one of its manufacturing centers, it would be a source of revenue, but not one directly related to the manufacturing and sale of candy.

 

Income statements are presented as either multi-step or single-step. The end result (the net income or loss figure) is the same, and the differences are mainly in the ways that those two types of statements are formatted. A generalized view of each is below:

 

Multi-Step Format

Single-Step Format

Net sales

Net sales

Cost of sales

Materials and production

Gross income

Marketing and administrative

Selling, general, and administrative expenses

Research and development expenses

Operating income

Other income and expenses

Other income and expenses

Pretax income

Pretax income

Taxes

Taxes

Net income

Net income (after taxes)

---

 

The fundamental analyst often finds that comparing a company’s income statements from different time periods is helpful in assessing that company’s strength. For example, comparing income statements for two consecutive fiscal years gives the analyst a sense of how the company performed different in those years, as well as some idea of what the company leadership decided to prioritize from one year to the next. A company’s revenue (or sales) is often seen as the best way for that company to improve its profitability. Keep in mind, though, that there are different types of revenue: continuous revenue that operates from year to year is ideal, though there may also be short-term boosts to revenue thanks to promotions or special marketing. When a company increases its sales from one year to the next, it is a good sign that the fundamentals are strong. Similarly, rising profit margins suggest increases in efficiency and profitability, too.

 

Like balance sheets, income statements are typically available in 10-K filings as well as a company’s annual report.

 

Fundamental Analysis: The Balance Sheet

 

One of the most important aspects of fundamental analysis is quantitative analysis. Generally speaking, quantitative analysis focuses on fundamentals that are numeric and measurable. The most common source of quantitative fundamentals for an analyst examining a company is that company’s financial statement. The three primary elements making up financial statements for any business are the balance sheet, the income statement, and the cash flow statement. In the next three lessons, we’ll take a look at each of these three components and how fundamental analysis can make use of them to find intrinsic value.

 

First, the balance sheet. A company’s balance sheet is a record of all of its assets, liabilities, and equity. It is a snapshot that shows a company’s status at a particular point in time. It is called a balance sheet because any business’s financial structure is “balanced” in this way:

 

Assets = Liabilities + Shareholders’ Equity

 

In this equation, assets stand for the resources under the company’s control at a given point in time. Assets may include a variety of items, such as cash holdings, inventory, equipment, real estate, and more. On the opposite side of the equation are the sources of financing that the company has used to acquire those assets. Liabilities represent debt which must be repaid at some point in the future and is opposed to equity, which stands for the total value of money that the company owners have contributed to the company itself. Equity includes retained earnings, or the company’s profit from previously in its history.

 

Most often, balance sheets are provided at the end of a fiscal year as a way of summing up the company’s position at that time. Here is a sample balance sheet:

Source: https://www.investopedia.com

 

As you can see, this balance sheet indicates the company and date at the top, and then has sections for assets and liabilities/shareholders’ equity. Assets are generally listed in order of liquidity, and liabilities are listed according to when they will be paid. “Current” or “short-term” liabilities are ones that the company expects to pay within the year, while “long-term” ones are to be paid after that.

 

U.S. companies submit financial statements including balance sheets to the Securities and Exchange Commission (SEC) periodically. These documents and others relating to a company are available to the public as part of that company’s annual 10-K and quarterly 10-Q filings with the SEC. These documents are available either online or in hard copy form.

 

Fundamental Analysis: The Cash Flow Statement

 

The third critical tool for the quantitative aspect of fundamental analysis is the cash flow statement. This statement reveals how much cash comes in and goes out of a particular company, either over a quarter or for a year’s time. This may seem to be very similar to the income statement, but there are crucial differences between the two.

 

The main difference between the cash flow statement and the income statement is accrual accounting. Accrual accounting is used in the income statement and refers to the process by which companies log revenues and expenses as the transactions occur, not when cash is actually transferred in or out of the company. For this reason, in reading an income statement which says that the net income for a company is X, that statement is not necessarily a reflection of an increase in the company’s balance sheet by X.

 

In this way, the cash flow statement is a more straightforward way of gleaning a sense of a company’s cash profit. A cash flow statement which indicates X in net cash inflow means that the company has X more in cash than it did at the end of the previous period.

 

What makes a cash flow statement useful in fundamental analysis? The most important aspect of the cash flow statement is that it shows exactly how much cash a company has generated or lost. Looking at the cash flow statement will reveal if a company is able to pay for its current operations and if it’s able to continue to grow. Companies that have net profits on their income statements can still have trouble because of insufficient cash flows, and that can impact the company’s intrinsic value.

 

Most cash flow statements are broadly separated into three sections, with one section for operations, one for financing, and a third for investing. The first two of these sections reveal how the company gets its cash, and the third shows how the company spends its cash.

 

Cash flows from operating activities will reveal how much of the company’s cash comes from the sales of its goods and services (less the cash required to produce and sell those items and services). Fundamental analysts look for companies with a net positive cash flow from their operating activities. On the other hand, some high growth companies will show negative cash flow as a result of operations, particularly when they are first starting out.

 

Cash flows from financing activities are related to cash being moved not as a direct result of the creation and sale of the company’s products. This category might include the selling of stock or the repayment of a bank loan.

 

Cash flows from investing activities are those related to capital expenditures like new equipment, or to acquisitions and monetary investments. Many successful companies re-invest capital in their business at or above the rate of depreciation expenses each year. Fundamental analysts should be on the lookout for companies which do not do this, as the result might be artificially high cash inflows.

 

The cash flow statement can be a difficult document to parse out. Keep in mind what it does and does not show, and also be watchful for companies that generate strong levels of free cash flow. These companies tend to be the ones which are able to pay back debt, pay out dividends, buy back stock, and grow more readily than others. The stronger a company’s free cash flow, the less it needs to rely on external financing to maintain its operations and grow. To calculate the free cash flow of a company, follow this formula:

 

Net income

+ Amortization/Depreciation

- Changes in working capital

- Capital Expenditures

---------------------------------

= Free cash flow

 

10. Fundamental Analysis: A Brief Introduction to Valuation

 

One of the most important premises in fundamental analysis has to do with a company’s discounted cash flow (DCF). Put simply, a DCF is a means of valuation which estimates the future profits of a company. A company is worth all of these profits combined, although you must also discount them in order to account for the time value of money, meaning the degree to which each dollar you receive in a year’s time is worth less than a dollar you would receive in the present.

 

This can be a somewhat difficult concept to wrap one’s mind around, so we’ll put it in a different way. From the perspective of a small business owner, the business is worth as much money as you believe you can make from the company from now until the end of the business. If you own the business, you can only take some of the money for yourself once you have paid for all of your various expenses, supplies, salaries, reinvestments, etc.

 

To calculate DCF, use the following equation:

 

 

If a company will generate, say, $1 per share in cash flow for its shareholders for every year in the future, we can use this equation to calculate what that cash flow is worth to the value of the company today. This is another means of determining intrinsic value.

 

Discounted cash flow as a means of valuation uses many different techniques depending upon the type of cash flow used for the analysis. For example, a model known as the dividend discount model prioritizes the dividends that a company pays out to its shareholders. Using this or a different model for determining discount cash flow allows you to focus your analysis through a particular lens, but each model ultimately aims for the same goal: a better understanding of the intrinsic value of a company, which contributes to overall fundamental analysis.

 

Another means of gaining insight into a company’s valuation and performance is the use of financial ratios. Valuation ratios compare various aspects of a company’s price and performance in order to provide context for comparison. Two of the most important and popular valuation ratios are price-to-book and price-to-earnings.

 

Price-to-book ratios (P/B ratios) compare the price of a company per share to the company’s book value. This ratio is compared on an absolute basis, and investors generally consider a price-to-book ratio below ‘1’ to be undervalued. Price-to-earnings ratios (P/E ratios) compare the share price to per-share earnings. This can be determined by comparing the market value per share to the earnings per share. The higher the P/E ratio, the greater the expectation among investors that the company will experience significant earnings growth in the future. A low P/E, on the other hand, may suggest that a company is undervalued, or perhaps that the company is doing very well in comparison with its previous trends.


Fundamental Analysis: Qualitative
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