Investors make investment decisions on the basis of technical analysis and fundamental analysis. Here, we will learn how to do fundamental analysis using financial statements, and financial ratios and take valuable insights from them.

Industry analysis

To understand a company’s potential, it’s crucial to study the industry in which the company operates to get valuable insights into its growth prospects, risk, and competition.

HOW TO ANALYZE INDUSTRY POTENTIAL?

• GDP contribution growth of the industry.
• Competitive landscape
  • Number of competitors
  • Market size
• Barrier to entry

COMPANY ANALYSIS

Company analysis includes evaluating the company’s business. This includes-

Management discussion and analysis

Companies upload insights from their general meetings periodically. These meetings include their growth strategies, market conditions, risks, etc which can be useful to evaluate a company. Some key points to consider are:

• Various segments the company operates in
• A major source of revenue
• Potential
• MOAT (Ability of business to maintain a competitive edge over its competitors.)
• Growth prospects
• Risks
• Business strategies

Shareholding pattern analysis

The shareholding pattern of a company gives valuable insights into ownership and the level of control within the company. This includes FIIs, DIIs, the Public, and promoters.

An increase in FIIs and DIIs stake ideally indicates their confidence in the growth potential of the company. Similarly, a decrease in their stake could be due to several factors. It is ideally a matter of concern. 

Consolidated financial statements

Financial statements of a company include income statements, balance sheets, and cash flow statements. These documents provide a comprehensive overview of the financial position of the company.

INCOME STATEMENT

The income statement of a company summarizes all incomes and expenditures over some time. It enables investors to evaluate the company’s operations. Here, is how you can use an income statement to evaluate a company.

• Revenue: Increasing revenue is generally considered as a positive signal as it indicates an increase in demand for the product that leads to an increase in sales. It can be influenced by the increase in the price of the product or volume of sales.
• Operating expenses:  Expenses include raw materials, salaries, rent, etc. An increase in operating expenses as a percentage of revenue can affect operating profit margin and net profit. Similarly, stable expenses indicate that the company’s expenses are well controlled and it leads to profitability.
• Profit after tax (PAT): Increasing PAT is a positive signal as it indicates that the company is generating more profit after accounting expenses.

Positive signals while evaluating income statements include an increase in revenue, an increase in PAT, and a stable/decrease in expenses concerning revenue.

BALANCE SHEET

The balance sheet reports the company’s assets, liabilities, and equity showing how the company’s resources are financed and allocated. It represents the financial position of the company. To evaluate a company using a balance sheet, we can analyze various components.

• Assets: Increase in assets is generally considered a positive signal as it indicates that the company is expanding, and diversifying which leads to growth.
• Liabilities: A decrease in debt is considered a positive signal as it indicates that the company is decreasing its financial obligations and improving its financial health. However, a significant decrease in debt without a corresponding increase in assets could indicate a lack of investment growth and less creditworthiness.
• Shareholder’s equity: Positive shareholder’s equity represents the net worth of the company. An increase in FIIs, DIIs, and Public stake is a positive signal as it indicates that company value is increasing. Shareholders have confidence in the potential growth of the company.

Total assets more than that of Total liabilities, i.e. total assets > total liabilities, is a positive signal. However, a constant increase in debt is generally considered a negative signal.

CASH FLOW STATEMENT

Cash flow statements provide information about the inflows and outflows of the cash within the company over a specific period of time. It is a summary of the allocation of funds in operating, investing, and financing activities.

• Operating activities: This shows the cash generated from the company’s core operations. An increase in cash flows from operating activities can be a positive signal, as it indicates efficient and effective management and profitability. However, a decrease in cash flow from operations can be a negative signal as it indicates issues with sales, cost, management, and profitability.
• Investing activities: It assesses the company’s cash related to investments in assets. A stable/ increase in cash inflows can be a positive signal as it indicates the selling of investments and having effective disinvestment strategies. When more percentage of profit is re-invested in the company, it indicates a positive signal. However negative signals may include outflows for investments without corresponding cash inflows, which suggests potential cash drains or over-investment.
• Financing activities: cash outflows indicate that the company is retiring debt and paying out dividends which might be a positive signal for investors. However, cash inflow indicates issuing stock or debt, which boosts asset levels.

A positive balance of net cash generated indicates the company’s ability to generate cash and meet its financial obligations while a negative balance indicates liquidity Challenges the Company is facing.

Financial ratios

Financial ratios are the quantitative tools used to evaluate a company’s financial position. They provide means to compare different aspects of a company’s financial statements. Investors use financial ratios to make informed decisions about a company’s liquidity, profitability, and solvency.

Earnings per share (EPS)

EPS is used to analyze the profitability of the company.

EPS= Profit after tax (PAT) / Number of outstanding shares.

Increase in EPS: An increase in PAT is considered as a positive signal as it indicates the company is generating more profits and a decrease in outstanding shares indicates a buyback of shares, which boosts EPS.

Decrease in EPS: A decrease in PAT is considered a negative signal as it indicates a decline in net income and an increase in outstanding shares indicates that the company sells more shares to the public which dilutes EPS unless newly issued shares generate significant profits.

A steady EPS is considered optimal. However frequent ups and downs can be a negative sign.

Price to earnings ratio (PE ratio)

PE ratio is used to analyze the valuation of a company’s stock. It suggests whether the stock is undervalued or overvalued, i.e. how much value investors are ready to pay for Rs 1 of the company’s earnings. Always compare PE with its peers.

PE ratio = Last traded price / EPS

When the company’s PE ratio is low, the stock is relatively undervalued, allowing investors to acquire the company’s earnings at a lower price. Conversely, when the PE ratio is high, indicating an overvalued stock, investors are paying a premium to purchase it. It also suggests investors’ expectations for the company’s growth.

 An increase in a company’s earnings indicates consistent growth and financial stability of the company which results in higher PE. However, the decline in earnings can be a concern about the growth and financial stability of the company, which leads to lower PE.

 Debt to Equity ratio

It represents the comparison between the debt and equity of the company. The ideal ratio is 2:1.

An increase in the ratio indicates an increase in debt, which is considered a negative signal. This suggests a higher dependency on loans which increases finance costs. A decrease in the ratio significantly suggests the low creditworthiness of the company, which again indicates a negative signal.

A lower ratio also indicates that the company relies less on borrowed funds and has a stronger financial position, which suggests better stability. A stable debt-to-equity ratio is considered optimal.

Interest coverage ratio

It represents the company’s ability to generate enough operating income to cover finance costs.

Interest coverage ratio = Earnings before interest and taxes / Interest expenses.

A higher ratio indicates that the company is capable of meeting finance costs, however, a lower ratio suggests the company may have difficulty in retiring its debt.

Return on equity (ROE)

It represents the efficiency of the company in generating profits from shareholders’ investments. Always compare ROE with its peers.

ROE = Total profit / Total equity

High/ Increasing ROE: It suggests a positive signal as the company is generating significant profits from shareholder’s investment. Debt should not have an influence over ROE.

Low/ Declining ROE: It suggests a negative signal as the company is not generating significant profits from shareholders’ investments. It represents its poor financial performance.

An increase in ROE and profit indicates a positive signal. However, an increase in debt is a negative signal.

Current Ratio

It is a comparison between current assets and current liabilities. The ideal ratio is 2:1. If the company’s current ratio is less than 2:1, it indicates a negative signal. This suggests that the company challenging liquidity. The optimal ratio is considered to be more than 2:1.

Margins

Margins = Revenue / PAT

An increase in margins suggests an increase in revenue and PAT which indicates a positive signal however, a decrease in margins indicates a negative signal.

Key points to remember while fundamentally analyzing companies

• Increasing Revenue
• Higher Margins
• Increasing EPS
• Increasing PAT
• Manageable debt
• Higher interest coverage ratio
• Higher ROE