Fundamentals
Part Four
Annual report
An annual
report provides a company's shareholders with information about its operations.
This is an obligation stipulated by law. This is extremely beneficial to
investors because it helps make informed decisions.
The report tells you how well the company is doing while also forecasting its
future earnings and dividends. The Chairman's letter in the report also
profiles the company's future goals.
Inside the Annual Report
Here is what comprises an annual report:
A letter from the chairman on the high points of business in the past year with
predictions for the next year.
The company philosophy: A section that describes the principles and ethics that
govern a company's business.
An extensive report on each section of operations within the company,
describing the company's services or the products
financial information that includes the profit and loss (P&L) statements
and a balance sheet Depending on its income and expenses, the company will
either make profits or show losses for a year. The balance sheet describes
assets and liabilities and compares them to the previous year. The footnotes
will also give you reveal important information, as they discuss current or
pending lawsuits or government regulations that may impact the company
operations.
An auditor's letter in the annual report confirms that the information provided
in the report is accurate and has been certified by independent accountants.
Obtain an Annual Report
Annual reports are mailed automatically to all shareholders on record. If you
wish to obtain the annual report about a company in which you do not own
shares, you can call its public relations (or shareholder relations)
department. You may also look at the company web site, or search the Internet; as
there are several sources on the Internet providing information on public
companies.
All publicly listed companies are required to submit the financial reports
available in the public domain as per SEBI regulations.
Quarterly
and other financial reports
besides the annual report, companies provide several other financial reports
such as quarterly reports (issued every three months) and statistical
supplements. These however are not as comprehensive as the annual report of the
company.
Quarterly reports are very similar to the annual reports except they are issued
every three months and are less comprehensive. They may be obtained in the same
way as an annual report.
Company
Earnings
Earnings are a company's net profit. It is the surplus left with the company
after it has cleared all its expenses, i.e. Money paid to employees, utility
bills, costs of production and other operating expenses The manner in which a
company makes its earnings, is defined by the very nature of its business.
Two sources of company earnings are:
Ø Income from sales of goods or services
Ø Income from investment.
Investments generate income for businesses by way of either interest on loans,
dividends from other businesses, or gains on the sale of investment property.
Thus, company earnings are the sum of income from sales or investment left
after the company has met its obligations.
Why are Earnings important
As an
investor who holds shares of the company, you have part ownership of company.
When you invest in a company's shares, you become a 'part owner' of the company
and you get to share a part of the company's profit as dividend. Thus, if the
company does well and earns more profit, you in turn to well If the company
reinvents its earnings towards future growth, you are assured of higher
dividends in the future.
Meanwhile, if you lend money to the company by investing in its bonds, the
company uses part of its earnings to repay interest and principle on the bonds.
The more earnings the company has, the more secure you can be that the company
will be able to make your interest payments. So, company earnings are important
to you because you make money when the business you invest in, makes money.
Use earnings information to make an investment decision
your investment goals determines how you use information about company
earnings. If you are an income investor, interested in earning immediate income
from your investments, you probably want to invest in a company that is paying
dividends. If you have a long-term investment strategy, dividends may not be as
important to you. The "financial s" indicate whether a company is
oriented for income, growth, or a bit of both. By comparing the financial s for
different companies in the same industry, you can find characteristics best suited
to your investment goals.
A convenient way to compare companies is through Earnings per share (EPS). EPS
represents the net profit divided by the number of outstanding shares of stock.
When you compare the EPS of different companies, be sure to consider the
following:
1 Companies with higher earnings are stronger than companies with lower
earnings.
2 Companies that reinvest their earnings may pay low or no dividends but may be
poised for growth.
3 Companies with lower earnings, and higher research and development costs, may
be on the brink of either a breakthrough or a disaster, making them a risky
proposition.
4 Companies with higher earnings, lower costs and lower shareholder equity,
might go in for a merger.
Use Fundamentals to make an investment decision
Fundamental Analysis is a method used to evaluate the worth of a security by
studying the financial data of the issuer. But this research can never
accurately predict how the company will perform in the stock market. It can
however be used as a good comparative framework to know which company will be a
better investment choice.
As an investor, you are interested in a corporation's earnings because earnings
assure higher dividends and potential for further growth. You can use
profitability ratios to compare earnings for prospective investments. These are
measures of performance showing how much the firm is earning compared to its
sales, assets or equity.
You can quickly see the difference in profitability between two companies by
comparing the profitability ratios of each. Let us see how ratio analysis
works.
Ratio Analysis
The ratio analysis technique is also called cross-sectional analysis, providing
you with important information about a company's financial strength.
Cross-sectional analysis compares financial ratios of several companies from
the same industry and enables you to deduce success, failure or progress of any
business. Thus, a financial ratio measures a company's performance in a
specific area and guides your judgment regarding which company is a better
investment option. Some of the important ratios that an investor must know are:
i)
Price-Earnings Ratio((P-E ratio):
It is a ratio obtained by dividing the price of a share of stock by Earnings
per share (EPS) for a 12-month period.
ii)
EPS (Earnings Per Share):
It is that portion of a company's net income, which corresponds to each share
of that company's common stock which is issued and outstanding. EPS gives an
indication of the profitability of a company. It is calculated using the
formula:
EPS =
Net Income-Dividends on Preferred Stock
Average
Outstanding Shares
iii) Current Ratio: Companies need a surplus supply of current assets in order
to meet their current liabilities. They generally pay their interest payments
and other short-term debts with current assets. If a company has only illiquid
assets, it may not be able to make payments on their debts. It is a type of
Liquidity ratio.
Current Ratio =
Current Assets
Current
Liabilities
Leverage Ratios:
Traditionally, leverage is related to the relative proportions of debt and
equity, which fund a venture. The higher the proportion of debt, the more
leverage.
It is a ratio that measures a company's capital structure, indicating how a
company finances their assets. Do they rely strictly on equity? Or, do they use
a combination of equity and debt? The answers to these questions are of great
importance to investors.
Leverage=
Long Term Debt
Total
Equity
A firm that finances its assets with a high percentage of debt is risking
bankruptcy, higher borrowing costs and decreased financial flexibility; if its
performance cannot help fulfill its debt payments. If a company is highly
leveraged, it is also possible that lender's may shy away from providing
further debt financing fearing the viability of their investment.
The optimal capital structure for a company you invest in, depends on which
type of investor you are. A bondholder would prefer a company with very little debt
financing because of it lowers the risk of him losing his money.
When a firm becomes over leveraged, bankruptcy can result.
Shareholder's Equity:
Shareholders' equity is calculated as the value of a company's assets less the
value of its liabilities. It is the value of a business to its owners, after
all of its obligations have been met. This net worth belongs to the owners.
Shareholders' equity generally reflects the amount of capital the owners
invested, plus any profits that the company generates.
Bankruptcy
Bankruptcy is a legal mechanism that allows creditors to assume control of a
firm when it can no longer has the ability to meet its financial obligations.
Both stock and bond fear bankruptcy. Generally, the firm's assets are sold in
order to pay off creditors to the largest extent possible.
When bankruptcy occurs, stockholders of a corporation can only lose the amount
they have invested in the bankrupt company. This is called Limited Liability.
If a firm's liabilities exceed the liquidation value of their assets, (the
value of assets converted into cash), creditors also stand to lose money on
their investments.
Understanding the Balance Sheet
The balance sheet is one of the most important financial statements of a
company. The logic behind producing a balance sheet is to ensure that the
accounts are always in balance and all the company funds can be accounted for.
It is reported to investors at least once a year. You may also receive
quarterly, semiannually or monthly balance sheets. The contents of a balance
sheet include:
What the company owns (its assets)
What it owes (its liabilities)
The value of the business to its stockholders (the shareholders' equity).
Importance of Balance Sheet
As an
investor you need to ensure that the company you have invested in, has good
potential for future growth and will yield good returns. The balance sheet
helps you get answers to questions like:
1· Will the firm meet its financial obligations?
2. What amount of funds has already been invested in this company?
3. Is the company overly indebted?
4. What are the different assets that the company has purchased with its
financing?
These are just a few of the many relevant questions you can answer by studying
the balance sheet. The balance sheet provides a diligent investor with many
clues to a firm's future performance.
Assets
Assets are any items of economic value owned by a corporation that can be
converted into cash.
Types of Assets:
Current assets are assets that are usually converted to cash within one year.
Bondholders and other creditors closely monitor a firm's current assets since
interest payments are generally made from current assets. Also in case the
company goes bankrupt, assets can be easily liquidated into cash and help
prevent loss of your investments. Current assets are important to most
companies, as they are a source of funds for day-to-day operations. It is thus
evident, that the more current assets a company owns, the better it is
performing.
Cash equivalents are not cash but can be converted into cash so easily that
they are considered equal to cash. Cash equivalents are generally highly
liquid, short-term and very safe investments.
Accounts Receivable
Accounts receivable is the money customers (individuals or corporations) owe
the firm in exchange for goods or services that have been delivered or used but
not yet paid for.
As more and more business is being done today with credit instead of cash, this
item is a significant component of the balance sheet. Accounts receivable is
however recorded as an asset on the balance sheet as it represents a legal
obligation for the customer to remit cash.
Inventory
a firms inventory is the stock of materials used to manufacture their products
and the products themselves for future sale. A manufacturing company will often
have three different types of inventory: raw materials, works-in-process, and
finished goods. A retail firm's inventory generally will consist only of
products purchased that are still to be stored. Inventory is recorded as an asset
on a company's balance sheet.
Long-term Assets:
Long-term assets are grouped into several categories like:
A long-term, tangible asset held for business use and not expected to be
converted to cash in the current or upcoming fiscal year, such as manufacturing
equipment, real estate, and furniture.
Fixed assets are long-term, tangible assets held for business use and will not
be converted into cash in the current or upcoming year.
E.g. Items such as equipment, buildings, production plants and property On the
balance sheet, these are valued at their cost. As the value of the asset
declines over the years, depreciation is subtracted from all, except land.
Fixed assets are very important to a company because they represent long-term
investments that will not be liquidated soon and can facilitate the company’s
earnings.
Depreciation gives you an estimate of the decrease in the value of an asset,
caused by 'wear and tear' or obsolesces. It appears in the balance sheet as a
deduction from the original value of the fixed assets; as the value of the
fixed asset decreases due to wear and tear.
Intangible assets are non-physical assets such as copyrights, franchises and
patents. Being intangible, it becomes difficult to estimate their value. Often
there is no ready market for them. Sometimes however, an intangible asset can
be the most valuable asset a company possesses.
Liabilities
Liabilities are a company's debt to outside parties. They represent rights of
others to expect money or services of the company. A company that has too many
liabilities may be in danger of going bankrupt. E.g. Bank loans, debts to
suppliers and debts to its employees. On the balance sheet, liabilities are
generally broken down into Current Liabilities and Long-Term Liabilities.
Types of Liabilities:
Current liabilities
Current liabilities are debts currently owed for taxes, salaries, interest,
accounts payable* and notes payable, that are due within one year.
A company is considered to have good financial strength when current assets
exceed current liabilities.
Accounts Payable
Accounts payable is one of a series of accounting transactions covering
payments to suppliers whom the company owes money for goods and services.
Therefore, you will often see accounts payable on most balance sheets.
Long-term debt is a long-term loan, for a period greater than one year.
These debts are often paid in installments. If this is the case, the portion to
be paid off in the current year is considered a current liability.
