INTRO

1. WHAT IS FUNDAMENTAL ANALYSIS

2. QUALITATIVE FACTORS -COMPANY

3. QUALITATIVE FACTORS -INDUSTRY

4. INTRO TO FINANCIAL STATEMENTS

5. OTHER IMPORTANT SECTIONS FOUND IN FINANCIAL FILLINGS

6. INCOME STATEMENT

7. BALANCE SHEET

8. CASH FLOW STATEMENTS

9. INTO TO VALUATION

10. CONCLUSION

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Introduction

Fundamental analysis is a method of finding out the future price of a

security which an investor wants to buy. The objective of fundamental
analysis is to appraise the intrinsic value of the security. There is an
intrinsic value of each security and it can be determined by making an
analysis of fundamental factors relating to the company, industry and
economy. At any given point of time, the current market price of the
security can be different from its intrinsic value dude to the temporary
market conditions. An investor can buy undervalued securities and sell
overvalued securities. Thus, the intrinsic value of a security should be
determined for this purpose.

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Economic analysis
Company analysis
Industry analysis

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WHAT IS FUNDAMENTAL ANALYSIS

When talking about stocks, fundamental analysis is a technique that

attempts to determine a security’s value by focusing on underlying
factors that affect a company's actual business and its future prospects.
On a broader scope, you can perform fundamental analysis on industries
or the economy as a whole. The term simply refers to the analysis of the
economic well-being of a financial entity as opposed to only its price
movements.

Fundamental analysis serves to answer questions, such as:

 Is the company’s revenue growing?

 Is it actually making a profit?
 Is it in a strong-enough position to beat out its competitors in the
future?
 Is it able to repay its debts?
 Is management trying to "cook the books"?

Of course, these are very involved questions, and there are literally
hundreds of others you might have about a company. It all really boils
down to one question: Is the company’s stock a good investment? Think
of fundamental analysis as a toolbox to help you answer this question.

Note: The term fundamental analysis is used most often in the context of
stocks, but you can perform fundamental analysis on any security, from
a bond to a derivative. As long as you look at the economic
fundamentals, you are doing fundamental analysis.

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Fundamentals: Quantitative and Qualitative

You could define fundamental analysis as “researching the

fundamentals”, but that doesn’t tell you a whole lot unless you know
what fundamentals are. As we mentioned in the introduction, the big
problem with defining fundamentals is that it can include anything related
to the economic well-being of a company. Obvious items include things
like revenue and profit, but fundamentals also include everything from a
company’s market share to the quality of its management.

The various fundamental factors can be grouped into two categories:

quantitative and qualitative. The financial meaning of these terms isn’t all
that different from their regular definitions. Here is how the MSN Encarta
dictionary defines the terms:

 Quantitative – capable of being measured or expressed in

numerical terms.
 Qualitative – related to or based on the quality or character of
something, often as opposed to its size or quantity.

In our context, quantitative fundamentals are numeric, measurable

characteristics about a business. It’s easy to see how the biggest source
of quantitative data is the financial statements. You can measure
revenue, profit, assets and more with great precision.

Turning to qualitative fundamentals, these are the less tangible factors

surrounding a business - things such as the quality of a company’s
board members and key executives, its brand-name recognition, patents
or proprietary technology.
Quantitative Meets Qualitative
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Neither qualitative nor quantitative analysis is inherently better than the
other. Instead, many analysts consider qualitative factors in conjunction
with the hard, quantitative factors. Take the Coca-Cola Company, for
example. When examining its stock, an analyst might look at the stock’s
annual dividend payout, earnings per share, P/E ratio and many other
quantitative factors. However, no analysis of Coca-Cola would be
complete without taking into account its brand recognition. Anybody can
start a company that sells sugar and water, but few companies on earth
are recognized by billions of people. It’s tough to put your finger on
exactly what the Coke brand is worth, but you can be sure that it’s an
essential ingredient contributing to the company’s ongoing success.

The Concept of Intrinsic Value

Before we get any further, we have to address the subject of intrinsic
value. One of the primary assumptions of fundamental analysis is that
the price on the stock market does not fully reflect a stock’s “real” value.
After all, why would you be doing price analysis if the stock market were
always correct? In financial jargon, this true value is known as the
intrinsic value.

For example, let’s say that a company’s stock was trading at $20. After
doing extensive homework on the company, you determine that it really
is worth $25. In other words, you determine the intrinsic value of the firm
to be $25. This is clearly relevant because an investor wants to buy
stocks that are trading at prices significantly below their estimated
intrinsic value.

This leads us to one of the second major assumptions of fundamental

analysis: in the long run, the stock market will reflect the fundamentals.

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There is no point in buying a stock based on intrinsic value if the price
never reflected that value. Nobody knows how long “the long run” really
is. It could be days or years.

This is what fundamental analysis is all about. By focusing on a

particular business, an investor can estimate the intrinsic value of a firm
and thus find opportunities where he or she can buy at a discount. If all
goes well, the investment will pay off over time as the market catches up
to the fundamentals.

The big unknowns are:

1)You don’t know if your estimate of intrinsic value is correct; and
2)You don’t know how long it will take for the intrinsic value to be
reflected in the marketplace.

Criticisms of Fundamental Analysis

The biggest criticisms of fundamental analysis come primarily from two
groups: proponents of technical analysis and believers of the “efficient
market hypothesis”.

Technical analysis is the other major form of security analysis. We’re not
going to get into too much detail on the subject.
Put simply, technical analysts base their investments (or, more precisely,
their trades) solely on the price and volume movements of securities.
Using charts and a number of other tools, they trade on momentum, not
caring about the fundamentals. While it is possible to use both
techniques in combination, one of the basic tenets of technical analysis
is that the market discounts everything. Accordingly, all news about a

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company already is priced into a stock, and therefore a stock’s price
movements give more insight than the underlying fundamental factors of
the business itself.

Followers of the efficient market hypothesis, however, are usually in

disagreement with both fundamental and technical analysts. The efficient
market hypothesis contends that it is essentially impossible to produce
market-beating returns in the long run, through either fundamental or
technical analysis. The rationale for this argument is that, since the
market efficiently prices all stocks on an ongoing basis, any opportunities
for excess returns derived from fundamental (or technical) analysis
would be almost immediately whittled away by the market’s many
participants, making it impossible for anyone to meaningfully outperform
the market over the long term.

QUALITATIVE FACTORS -COMPANY

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Fundamental analysis seeks to determine the intrinsic value of a
company's stock. But since qualitative factors, by definition, represent
aspects of a company's business that are difficult or impossible to
quantify, incorporating that kind of information into a pricing evaluation
can be quite difficult. On the flip side, as we've demonstrated, you can't
ignore the less tangible characteristics of a company.

Business Model
Even before an investor looks at a company's financial statements or
does any research, one of the most important questions that should be
asked is: What exactly does the company do? This is referred to as a
company's business model – it's how a company makes money.
Sometimes business models are easy to understand. Take McDonalds,
for instance, which sells hamburgers, fries, soft drinks, salads and
whatever other new special they are promoting at the time. It's a simple
model, easy enough for anybody to understand.

Other times, you'd be surprised how complicated it can get. Boston

Chicken Inc. is a prime example of this. Back in the early '90s its stock
was the darling of Wall Street. At one point the company's CEO bragged
that they were the "first new fast-food restaurant to reach $1 billion in
sales since 1969". The problem is, they didn't make money by selling
chicken. Rather, they made their money from royalty fees and high-
interest loans to franchisees. Boston Chicken was really nothing more
than a big franchisor. On top of this, management was aggressive with
how it recognized its revenue. As soon as it was revealed that all the
franchisees were losing money, the house of cards collapsed and the
company went bankrupt.

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At the very least, you should understand the business model of any
company you invest in. The "Oracle of Omaha", Warren Buffett, rarely
invests in tech stocks because most of the time he doesn't understand
them. This is not to say the technology sector is bad, but it's not Buffett's
area of expertise; he doesn't feel comfortable investing in this area.
Similarly, unless you understand a company's business model, you don't
know what the drivers are for future growth, and you leave yourself
vulnerable to being blindsided like shareholders of Boston Chicken were.

Competitive Advantage
Another business consideration for investors is competitive advantage. A
company's long-term success is driven largely by its ability to maintain a
competitive advantage - and keep it. Powerful competitive advantages,
such as Coca Cola's brand name and Microsoft's domination of the
personal computer operating system, create a moat around a business
allowing it to keep competitors at bay and enjoy growth and profits.
When a company can achieve competitive advantage, its shareholders
can be well rewarded for decades.

Management
Just as an army needs a general to lead it to victory, a company relies
upon management to steer it towards financial success. Some believe
that management is the most important aspect for investing in a
company. It makes sense - even the best business model is doomed if
the leaders of the company fail to properly execute the plan.

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So how does an average investor go about evaluating the management
of a company?

This is one of the areas in which individuals are truly at a disadvantage

compared to professional investors. You can't set up a meeting with
management if you want to invest a few thousand dollars. On the other
hand, if you are a fund manager interested in investing millions of
dollars, there is a good chance you can schedule a face-to-face meeting
with the upper brass of the firm.

Every public company has a corporate information section on its

website. Usually there will be a quick biography on each executive with
their employment history, educational background and any applicable
achievements. Don't expect to find anything useful here. Let's be honest:
We're looking for dirt, and no company is going to put negative
information on its corporate website.

Instead, here are a few ways for you to get a feel for management:

1. Conference Calls
The Chief Executive Officer (CEO) and Chief Financial Officer (CFO)
host quarterly conference calls. (Sometimes you'll get other executives
as well.) The first portion of the call is management basically reading off
the financial results. What is really interesting is the question-and-
answer portion of the call. This is when the line is open for analysts to
call in and ask management direct questions. Answers here can be
revealing about the company, but more importantly, listen for candor. Do
they avoid questions, like politicians, or do they provide forthright
answers?

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2. Management Discussion and Analysis (MD&A)
The Management Discussion and Analysis is found at the beginning of
the annual report (discussed in more detail later in this tutorial). In
theory, the MD&A is supposed to be frank commentary on the
management's outlook.

One tip is to compare what management said in past years with what
they are saying now. Is it the same material rehashed? Have strategies
actually been implemented?

3. Ownership and Insider Sales

Just about any large company will compensate executives with a
combination of cash, restricted stock and options. While there are
problems with stock options (See Putting Management Under the
Microscope), it is a positive sign that members of management are also
shareholders. The ideal situation is when the founder of the company is
still in charge. Examples include Bill Gates (in the '80s and '90s),
Michael Dell and Warren Buffett. When you know that a majority of
management's wealth is in the stock, you can have confidence that they
will do the right thing. As well, it's worth checking out if management has
been selling its stock. This has to be filed with the Securities and
Exchange Commission (SEC), so it's publicly available information. Talk
is cheap - think twice if you see management unloading all of its shares
while saying something else in the media.

4. Past Performance
Another good way to get a feel for management capability is to check
and see how executives have done at other companies in the past. You
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can normally find biographies of top executives on company web sites.
Identify the companies they worked at in the past and do a search on
those companies and their performance.

Corporate Governance
Corporate governance describes the policies in place within an
organization denoting the relationships and responsibilities between
management, directors and stakeholders. These policies are defined
and determined in the company charter and its bylaws, along with
corporate laws and regulations. The purpose of corporate governance
policies is to ensure that proper checks and balances are in place,
making it more difficult for anyone to conduct unethical and illegal
activities.

Good corporate governance is a situation in which a company complies

with all of its governance policies and applicable government regulations
in order to look out for the interests of the company's investors and other
stakeholders.

Although, there are companies and organizations (such as Standard &

Poor's) that attempt to quantitatively assess companies on how well their
corporate governance policies serve stakeholders, most of these reports
are quite expensive for the average investor to purchase.

Fortunately, corporate governance policies typically cover a few general

areas: structure of the board of directors, stakeholder rights and financial

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and information transparency. With a little research and the right
questions in mind, investors can get a good idea about a company's
corporate governance.

Financial and Information Transparency

This aspect of governance relates to the quality and timeliness of a
company's financial disclosures and operational happenings. Sufficient
transparency implies that a company's financial releases are written in a
manner that stakeholders can follow what management is doing and
therefore have a clear understanding of the company's current financial
situation.

Stakeholder Rights
This aspect of corporate governance examines the extent that a
company's policies are benefiting stakeholder interests, notably
shareholder interests. Ultimately, as owners of the company,
shareholders should have some access to the board of directors if they
have concerns or want something addressed. Therefore companies with
good governance give shareholders a certain amount of ownership
voting rights to call meetings to discuss pressing issues with the board.

Another relevant area for good governance, in terms of ownership rights,

is whether or not a company possesses large amounts of takeover
defenses or other measures that make it difficult for changes in
management, directors and ownership to occur.

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Structure of the Board of Directors
The board of directors is composed of representatives from the company
and representatives from outside of the company. The combination of
inside and outside directors attempts to provide an independent
assessment of management's performance, making sure that the
interests of shareholders are represented.

The key word when looking at the board of directors is independence.

The board of directors is responsible for protecting shareholder interests
and ensuring that the upper management of the company is doing the
same. The board possesses the right to hire and fire members of the
board on behalf of the shareholders. A board filled with insiders will often
not serve as objective critics of management and will defend their
actions as good and beneficial, regardless of the circumstances.

We've now gone over the business model, management and corporate
governance. These three areas are all important to consider when
analyzing any company. We will now move on to looking at qualitative
factors in the environment in which the company operates.

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QUALITATIVE FACTORS -INDUSTRY

Customers
Some companies serve only a handful of customers, while others serve
millions. In general, it's a red flag (a negative) if a business relies on a
small number of customers for a large portion of its sales because the
loss of each customer could dramatically affect revenues. For example,
think of a military supplier who has 100% of its sales with the U.S.
government. One change in government policy could potentially wipe out
all of its sales. For this reason, companies will always disclose in their
10-K if any one customer accounts for a majority of revenues.

Market Share
Understanding a company's present market share can tell volumes
about the company's business. The fact that a company possesses an
85% market share tells you that it is the largest player in its market by
far. Furthermore, this could also suggest that the company possesses
some sort of "economic moat," in other words, a competitive barrier
serving to protect its current and future earnings, along with its market
share. Market share is important because of economies of scale. When
the firm is bigger than the rest of its rivals, it is in a better position to
absorb the high fixed costs of a capital-intensive industry.

Industry Growth
One way of examining a company's growth potential is to first examine
whether the amount of customers in the overall market will grow. This is
crucial because without new customers, a company has to steal market
share in order to grow.

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In some markets, there is zero or negative growth, a factor demanding
careful consideration. For example, a manufacturing company dedicated
solely to creating audio compact cassettes might have been very
successful in the '70s, '80s and early '90s. However, that same company
would probably have a rough time now due to the advent of newer
technologies, such as CDs and MP3s. The current market for audio
compact cassettes is only a fraction of what it was during the peak of its
popularity.

Competition
Simply looking at the number of competitors goes a long way in
understanding the competitive landscape for a company. Industries that
have limited barriers to entry and a large number of competing firms
create a difficult operating environment for firms.

One of the biggest risks within a highly competitive industry is pricing

power. This refers to the ability of a supplier to increase prices and pass
those costs on to customers. Companies operating in industries with few
alternatives have the ability to pass on costs to their customers. A great
example of this is Wal-Mart. They are so dominant in the retailing
business, that Wal-Mart practically sets the price for any of the suppliers
wanting to do business with them. If you want to sell to Wal-Mart, you
have little, if any, pricing power.

Regulation
Certain industries are heavily regulated due to the importance or severity
of the industry's products and/or services. As important as some of these
regulations are to the public, they can drastically affect the attractiveness
of a company for investment purposes.

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In industries where one or two companies represent the entire industry
for a region (such as utility companies), governments usually specify
how much profit each company can make. In these instances, while
there is the potential for sizable profits, they are limited due to regulation.

In other industries, regulation can play a less direct role in affecting

industry pricing. For example, the drug industry is one of most regulated
industries. And for good reason - no one wants an ineffective drug that
causes deaths to reach the market. As a result, the U.S. Food and Drug
Administration (FDA) requires that new drugs must pass a series of
clinical trials before they can be sold and distributed to the general
public. However, the consequence of all this testing is that it usually
takes several years and millions of dollars before a drug is approved.
Keep in mind that all these costs are above and beyond the millions that
the drug company has spent on research and development.

All in all, investors should always be on the lookout for regulations that
could potentially have a material impact upon a business' bottom line.
Investors should keep these regulatory costs in mind as they assess the
potential risks and rewards of investing.

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INTRO TO FINANCIAL STATEMENTS

Financial statements are the medium by which a company discloses

information concerning its financial performance. Followers
of fundamental analysis use the quantitative information gleaned from
financial statements to make investment decisions. Before we jump into
the specifics of the three most important financial statements - income
statements, balance sheets and cash flow statements - we will briefly
introduce each financial statement's specific function, along with where
they can be found.

The Major Statements

The Balance Sheet

The balance sheet represents a record of a company's assets, liabilities
and equity at a particular point in time. The balance sheet is named by
the fact that a business's financial structure balances in the following
manner:

Assets = Liabilities + Shareholders' Equity

Assets represent the resources that the business owns or controls at a

given point in time. This includes items such as cash, inventory,
machinery and buildings. The other side of the equation represents the
total value of the financing the company has used to acquire those

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assets. Financing comes as a result of liabilities or equity. Liabilities
represent debt (which of course must be paid back), while equity
represents the total value of money that the owners have contributed to
the business - including retained earnings, which is the profit made in
previous years.

The Income Statement

While the balance sheet takes a snapshot approach in examining a
business, the income statement measures a company's performance
over a specific time frame. Technically, you could have a balance sheet
for a month or even a day, but you'll only see public companies report
quarterly and annually.

The income statement presents information about revenues, expenses

and profit that was generated as a result of the business' operations for
that period.

Statement of Cash Flows

The statement of cash flows represents a record of a business' cash
inflows and outflows over a period of time. Typically, a statement of cash
flows focuses on the following cash-related activities:

 Operating Cash Flow (OCF): Cash generated from day-to-day

business operations
 Cash from investing (CFI): Cash used for investing in assets, as
well as the proceeds from the sale of other businesses, equipment
or long-term assets
 Cash from financing (CFF): Cash paid or received from the issuing
and borrowing of funds

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The cash flow statement is important because it's very difficult for a
business to manipulate its cash situation. There is plenty that aggressive
accountants can do to manipulate earnings, but it's tough to fake cash in
the bank. For this reason some investors use the cash flow statement as
a more conservative measure of a company's performance.

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OTHER IMPORTANT SECTIONS FOUND IN FINANCIAL FILLINGS

Management Discussion and Analysis (MD&A)

As a preface to the financial statements, a company's management will
typically spend a few pages talking about the recent year (or quarter)
and provide background on the company. This is referred to as
the management discussion and analysis (MD&A). In addition to
providing investors a clearer picture of what the company does, the
MD&A also points out some key areas in which the company has
performed well.

Here are some things to look out for:

 How candid and accurate are management's comments?

 Does management discuss significant financial trends over the
past couple years?
 How clear are management's comments? If executives try to
confuse you with big words and jargon, perhaps they have
something to hide.
 Do they mention potential risks or uncertainties moving forward?

Disclosure is the name of the game. If a company gives a decent

amount of information in the MD&A, it's likely that management is being
upfront and honest. It should raise a red flag if the MD&A ignores serious
problems that the company has been facing.

The Auditor's Report

The auditors' job is to express an opinion on whether the financial
statements are reasonably accurate and provide adequate disclosure.

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This is the purpose behind the auditor's report, which is sometimes
called the "report of independent accountants".

By law, every public company that trades stocks or bonds on an

exchange must have its annual reports audited by a certified public
accountants firm. An auditor's report is meant to scrutinize the company
and identify anything that might undermine the integrity of the financial
statements.

The typical auditor's report is almost always broken into three

paragraphs and written in the following fashion:

Independent Auditor's Report

Paragraph 1
Recounts the responsibilities of the auditor and
directors in general and lists the areas of the
financial statements that were audited.

Paragraph 2
Lists how the generally accepted accounting
principles (GAAP) were applied, and what areas of
the company were assessed.

Paragraph 3
Provides the auditor's opinion on the financial
statements of the company being audited. This is
simply an opinion, not a guarantee of accuracy.

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While the auditor's report won't uncover any financial bombshells, audits
give credibility to the figures reported by management. You'll only see
unaudited financials for unlisted firms. While quarterly statements aren't
audited, you should be very wary of any annual financials that haven't
been given the accountants' stamp of approval.

The Notes to the Financial Statements

Just as the MD&A serves an introduction to the financial statements, the
notes to the financial statements (sometimes called footnotes) tie up any
loose ends and complete the overall picture. If the income statement,
balance sheet and statement of cash flows are the heart of the financial
statements, then the footnotes are the arteries that keep everything
connected. Therefore, if you aren't reading the footnotes, you're missing
out on a lot of information.

The footnotes list important information that could not be included in the
actual ledgers. For example, they list relevant things like outstanding
leases, the maturity dates of outstanding debt and details on
compensation plans, such as stock options, etc.

Generally speaking there are two types of footnotes:

Accounting Methods - This type of footnote identifies and explains the

major accounting policies of the business that the company feels that
you should be aware of. This is especially important if a company has
changed accounting policies. It may be that a firm is practicing "cookie
jar accounting" and is changing policies only to take advantage of

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current conditions in order to hide poor performance.

Disclosure - The second type of footnote provides additional disclosure

that simply could not be put in the financial statements. The financial
statements in an annual report are supposed to be clean and easy to
follow. To maintain this cleanliness, other calculations are left for the
footnotes. For example, details of long-term debt - such as maturity
dates and the interest rates at which debt was issued - can give you a
better idea of how borrowing costs are laid out. Other areas of disclosure
include everything from pension plan liabilities for existing employees to
details about ominous legal proceedings involving the company.

The majority of investors and analysts read the balance sheet, income
statement and cash flow statement but, for whatever reason, the
footnotes are often ignored. What sets informed investors apart is
digging deeper and looking for information that others typically wouldn't.
No matter how boring it might be, read the fine print - it will make you a
better investor.

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INCOME STATEMENT

The income statement is basically the first financial statement you will
come across in an annual report or quarterly Securities And Exchange
Commission (SEC) filing.

It also contains the numbers most often discussed when a company

announces its results - numbers such as revenue, earnings and
earnings per share. Basically, the income statement shows how much
money the company generated (revenue), how much it spent (expenses)
and the difference between the two (profit) over a certain time period.

When it comes to analyzing fundamentals, the income statement lets

investors know how well the company’s business is performing - or,
basically, whether or not the company is making money. Generally
speaking, companies ought to be able to bring in more money than they
spend or they don’t stay in business for long. Those companies with low
expenses relative to revenue - or high profits relative to revenue - signal
strong fundamentals to investors.

Revenue as an investor signal:

Revenue, also commonly known as sales, is generally the most
straightforward part of the income statement. Often, there is just a single
number that represents all the money a company brought in during a
specific time period, although big companies sometimes break down
revenue by business segment or geography.

The best way for a company to improve profitability is by increasing

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sales revenue. For instance, Starbucks Coffee has aggressive long-term
sales growth goals that include a distribution system of 20,000 stores
worldwide. Consistent sales growth has been a strong driver of
Starbucks’ profitability.

The best revenue are those that continue year in and year out.
Temporary increases, such as those that might result from a short-term
promotion, are less valuable and should garner a lower price-to-earnings
multiple for a company.

What are the Expenses?

There are many kinds of expenses, but the two most common are the
cost of goods sold (COGS) and selling, general and administrative
expenses (SG&A). Cost of goods sold is the expense most directly
involved in creating revenue. It represents the costs of producing or
purchasing the goods or services sold by the company. For example, if
Wal-Mart pays a supplier $4 for a box of soap, which it sells to
customers for $5. When it is sold, Wal-Mart’s cost of goods sold for the
box of soap would be $4.

Next, costs involved in operating the business are SG&A. This category
includes marketing, salaries, utility bills, technology expenses and other
general costs associated with running a business. SG&A also includes
depreciation and amortization. Companies must include the cost of
replacing worn out assets. Remember, some corporate expenses, such
as research and development (R&D) at technology companies, are
crucial to future growth and should not be cut, even though doing so
may make for a better-looking earnings report. Finally, there are financial
costs, notably taxes and interest payments, which need to be

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considered.

Profits = Revenue - Expenses

Profit, most simply put, is equal to total revenue minus total expenses.
However, there are several commonly used profit subcategories that tell
investors how the company is performing. Gross profit is calculated as
revenue minus cost of sales. Returning to Wal-Mart again, the gross
profit from the sale of the soap would have been $1 ($5 sales price less
$4 cost of goods sold = $1 gross profit).

Companies with high gross margins will have a lot of money left over to
spend on other business operations, such as R&D or marketing. So be
on the lookout for downward trends in the gross margin rate over time.
This is a telltale sign of future problems facing the bottom line. When
cost of goods sold rises rapidly, they are likely to lower gross profit
margins - unless, of course, the company can pass these costs onto
customers in the form of higher prices.

Operating profit is equal to revenues minus the cost of sales and SG&A.
This number represents the profit a company made from its actual
operations, and excludes certain expenses and revenues that may not
be related to its central operations. High operating margins can mean
the company has effective control of costs, or that sales are increasing
faster than operating costs. Operating profit also gives investors an
opportunity to do profit-margin comparisons between companies that do
not issue a separate disclosure of their cost of goods sold figures (which
are needed to do gross margin analysis). Operating profit measures how
much cash the business throws off, and some consider it a more reliable
measure of profitability since it is harder to manipulate with accounting

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tricks than net earnings.

Net income generally represents the company's profit after all expenses,
including financial expenses, have been paid. This number is often
called the "bottom line" and is generally the figure people refer to when
they use the word "profit" or "earnings".

When a company has a high profit margin, it usually means that it also
has one or more advantages over its competition. Companies with high
net profit margins have a bigger cushion to protect themselves during
the hard times. Companies with low profit margins can get wiped out in a
downturn. And companies with profit margins reflecting a competitive
advantage is able to improve their market share during the hard times -
leaving them even better positioned when things improve again.

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BALANCE SHEET

The balance sheet highlights the financial condition of a company and is

an integral part of the financial statements.

The Balance Sheet's Main Three

Assets, liability and equity are the three main components of the balance
sheet. Carefully analyzed, they can tell investors a lot about a company's
fundamentals.

Assets
There are two main types of assets: current assets and non-current
assets. Current assets are likely to be used up or converted into cash
within one business cycle - usually treated as twelve months. Three very
important current asset items found on the balance sheet are: cash,
inventories and accounts receivables.

Investors normally are attracted to companies with plenty of cash on

their balance sheets. After all, cash offers protection against tough times,
and it also gives companies more options for future growth. Growing
cash reserves often signal strong company performance. Indeed, it
shows that cash is accumulating so quickly that management doesn't
have time to figure out how to make use of it. A dwindling cash pile could
be a sign of trouble. That said, if loads of cash are more or less a
permanent feature of the company's balance sheet, investors need to
ask why the money is not being put to use. Cash could be there because
management has run out of investment opportunities or is too short-
sighted to know what to do with the money.

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Inventories are finished products that haven't yet sold. As an investor,
you want to know if a company has too much money tied up in its
inventory. Companies have limited funds available to invest in inventory.
To generate the cash to pay bills and return a profit, they must sell the
merchandise they have purchased from suppliers. Inventory turnover
measures how quickly the company is moving merchandise through the
warehouse to customers. If inventory grows faster than sales, it is almost
always a sign of deteriorating fundamentals.

Receivables are outstanding (uncollected bills). Analyzing the speed at

which a company collects what it's owed can tell you a lot about its
financial efficiency. If a company's collection period is growing longer, it
could mean problems ahead. The company may be letting customers
stretch their credit in order to recognize greater top-line sales and that
can spell trouble later on, especially if customers face a cash crunch.
Getting money right away is preferable to waiting for it - since some of
what is owed may never get paid. The quicker a company gets its
customers to make payments, the sooner it has cash to pay for salaries,
merchandise, equipment, loans, and best of all, dividends and growth
opportunities.

Non-current assets are defined as anything not classified as a current

asset. This includes items that are fixed assets, such as property, plant
and equipment (PP&E). Unless the company is in financial distress and
is liquidating assets, investors need not pay too much attention to fixed
assets. Since companies are often unable to sell their fixed assets within
any reasonable amount of time they are carried on the balance sheet at
cost regardless of their actual value. As a result, it's is possible for

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companies to grossly inflate this number, leaving investors with
questionable and hard-to-compare asset figures.

Liabilities
There are current liabilities and non-current liabilities. Current liabilities
are obligations the firm must pay within a year, such as payments owing
to suppliers. Non-current liabilities, meanwhile, represent what the
company owes in a year or more time. Typically, non-current liabilities
represent bank and bondholder debt.

You usually want to see a manageable amount of debt. When debt

levels are falling, that's a good sign. Generally speaking, if a company
has more assets than liabilities, then it is in decent condition. By
contrast, a company with a large amount of liabilities relative to assets
ought to be examined with more diligence. Having too much debt relative
to cash flows required to pay for interest and debt repayments is one
way a company can go bankrupt.

Look at the quick ratio. Subtract inventory from current assets and then
divide by current liabilities. If the ratio is 1 or higher, it says that the
company has enough cash and liquid assets to cover its short-term debt
obligations.

Quick Ratio = Current Assets - Inventories

Current Liabilities

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Equity
Equity represents what shareholders own, so it is often called
shareholder's equity. As described above, equity is equal to total assets
minus total liabilities.

Equity = Total Assets – Total Liabilities

The two important equity items are paid-in capital and retained earnings.
Paid-in capital is the amount of money shareholders paid for their shares
when the stock was first offered to the public. It basically represents how
much money the firm received when it sold its shares. In other words,
retained earnings are a tally of the money the company has chosen to
reinvest in the business rather than pay to shareholders. Investors
should look closely at how a company puts retained capital to use and
how a company generates a return on it.

Most of the information about debt can be found on the balance sheet -
but some assets and debt obligations are not disclosed there. For
starters, companies often possess hard-to-measure intangible assets.
Corporate intellectual property (items such as patents, trademarks,
copyrights and business methodologies, goodwill and brand recognition )
are all common assets in today's marketplace. But they are not listed on
company's balance sheets.

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CASH FLOW STATEMENTS

Indeed, one of the most important features you should look for in a
potential investment is the company's ability to produce cash. Just
because a company shows a profit on the income statement doesn't
mean it cannot get into trouble later because of insufficient cash flows. A
close examination of the cash flow statement can give investors a better
sense of how the company will fare.

Three Sections of the Cash Flow Statement

Companies produce and consume cash in different ways, so the cash
flow statement is divided into three sections: cash flows from operations,
financing and investing. Basically, the sections on operations and
financing show how the company gets its cash, while the investing
section shows how the company spends its cash.

Cash Flows from Operating Activities

This section shows how much cash comes from sales of the company's
goods and services, less the amount of cash needed to make and sell
those goods and services. Investors tend to prefer companies that
produce a net positive cash flow from operating activities. High growth
companies, such as technology firms, tend to show negative cash flow
from operations in their formative years. At the same time, changes in
cash flow from operations typically offer a preview of changes in net
future income. Normally it's a good sign when it goes up. Watch out for a
widening gap between a company's reported earnings and its cash flow
from operating

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activities. If net income is much higher than cash flow, the company may
be speeding or slowing its booking of income or costs.

Cash Flows from Investing Activities

This section largely reflects the amount of cash the company has spent
on capital expenditures, such as new equipment or anything else that
needed to keep the business going. It also includes acquisitions of other
businesses and monetary investments such as money market funds.

You want to see a company re-invest capital in its business by at least

the rate of depreciation expenses each year. If it doesn't re-invest, it
might show artificially high cash inflows in the current year which may
not be sustainable.

Cash Flow From Financing Activities

This section describes the goings-on of cash associated with outside
financing activities. Typical sources of cash inflow would be cash raised
by selling stock and bonds or by bank borrowings. Likewise, paying back
a bank loan would show up as a use of cash flow, as would dividend
payments and common stock repurchases.

Cash Flow Statement Considerations:

Savvy investors are attracted to companies that produce plenty of free
cash flow (FCF). Free cash flow signals a company's ability to pay debt,
pay dividends, buy back stock and facilitate the growth of business. Free
cash flow, which is essentially the excess cash produced by the
company, can be returned to shareholders or invested in new growth
opportunities without

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hurting the existing operations. The most common method of calculating
free cash flow is:

Ideally, investors would like to see that the company can pay for the
investing figure out of operations without having to rely on outside
financing to do so. A company's ability to pay for its own operations and
growth signals to investors that it has very strong fundamentals.

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INTO TO VALUATION

While the concept behind discounted cash flow analysis is simple, its
practical application can be a different matter. The premise of the
discounted cash flow method is that the current value of a company is
simply the present value of its future cash flows that are attributable to
shareholders. Its calculation is as follows:

For simplicity's sake, if we know that a company will generate $1 per

share in cash flow for shareholders every year into the future; we can
calculate what this type of cash flow is worth today. This value is then
compared to the current value of the company to determine whether the
company is a good investment, based on it being undervalued or
overvalued.

There are several different techniques within the discounted cash flow
realm of valuation, essentially differing on what type of cash flow is used
in the analysis. The dividend discount model focuses on the dividends
the company pays to shareholders, while the cash flow model looks at
the cash that can be paid to shareholders after all expenses,
reinvestments and debt repayments have been made. But conceptually
they are the same, as it is the present value of these streams that are
taken into consideration.

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As we mentioned before, the difficulty lies in the implementation of the
model as there are a considerable amount of estimates and assumptions
that go into the model. As you can imagine, forecasting the revenue and
expenses for a firm five or 10 years into the future can be considerably
difficult.

Ratio Valuation
Financial ratios are mathematical calculations using figures mainly from
the financial statements, and they are used to gain an idea of a
company's valuation and financial performance. Some of the most well-
known valuation ratios are price-to-earnings and price-to-book. Each
valuation ratio uses different measures in its calculations. For example,
price-to-book compares the price per share to the company's book
value.

The calculations produced by the valuation ratios are used to gain some
understanding of the company's value. The ratios are compared on an
absolute basis, in which there are threshold values. For example, in
price-to-book, companies trading below '1' are considered undervalued.
Valuation ratios are also compared to the historical values of the ratio for
the company, along with comparisons to competitors and the overall
market itself.

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CONCLUSION

Whenever you’re thinking of investing in a company it is vital that you

understand what it does, its market and the industry in which it operates.
You should never blindly invest in a company.
One of the most important areas for any investor to look at when
researching a company is the financial statements. It is essential to
understand the purpose of each part of these statements and how to
interpret them.

Our learning’s:

 Financial reports are required by law and are published both

quarterly and annually.
 Management discussion and analysis (MD&A) gives investors a
better understanding of what the company does and usually points
out some key areas where it performed well.
 Audited financial reports have much more credibility than
unaudited ones.
 The balance sheet lists the assets, liabilities and shareholders'
equity.
 For all balance sheets: Assets = Liabilities + Shareholders’ Equity.
The two sides must always equal each other (or balance each
other).
 The income statement includes figures such as revenue,
expenses, earnings and earnings per share.
 For a company, the top line is revenue while the bottom line is net
income.

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 The income statement takes into account some non-cash items,
such as depreciation.
 The cash flow statement strips away all non-cash items and tells
you how much actual money the company generated.
 The cash flow statement is divided into three parts: cash from
operations, financing and investing.
 Always read the notes to the financial statements. They provide
more in-depth information on a wide range of figures reported in
the three financial statements.

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