Fundamentals of a business

Fundamental analysis provides valuable insights into a company's operations, profitability, and growth potential. By analyzing key financial indicators, investors can assess the strength and stability of a business, identify great investment opportunities, and make sound financial decisions.

The income statement, also known as the profit and loss statement, reveals a company's financial performance over a specific period. It shows the company's revenues, expenses, and net profit or loss during that time frame.

What does the income statement tell us? 

The income statement provides essential information about a company's ability to generate sales revenue, the costs associated with generating those revenues, and the resulting net profit. It helps us understand how effectively the company is making money and whether its financial performance is improving or declining.

When examining the income statement, there are a few key factors to consider:

• Revenue or sales: Analyze the trend of the company's sales revenue over time. Look for consistent growth or an upward trend.
• Cost of goods sold: This represents the expenses directly associated with producing or acquiring the goods sold by the company. A consistent or decreasing trend is preferable.
• Gross profit: Calculated by subtracting the cost of goods sold from the revenue, gross profit reveals the profitability of the company before accounting for operating expenses. Look for consistent growth or stability.
• Operating expenses: These are the costs incurred in running the day-to-day operations of the business, such as salaries, rent, and marketing expenses. Analyze the trend of these expenses and ensure they are manageable.
• Net profit: This is the final profit figure after deducting all expenses, including taxes. Look for consistent growth or improvement in net profit over time.

To evaluate a company's profitability, we can examine two important indicators:

• Gross profit margin: Calculated by dividing the gross profit by the revenue, the gross profit margin indicates the percentage of revenue that remains after accounting for the cost of goods sold. Look for a consistent or increasing gross profit margin, as it demonstrates the company's ability to control costs and maintain healthy profit margins.
• Net profit margin: Calculated by dividing the net profit by the revenue, the net profit margin reveals the percentage of revenue that translates into net profit. Look for a consistent or increasing net profit margin, indicating effective cost management and sustained profitability.

Case Study: Apple Inc. Let's apply the concepts of fundamental analysis to Apple Inc. and examine their income statement:

• Revenue: Analyzing Apple's revenue over the past five years, we observe a consistent upward trend, indicating strong sales growth.
• Gross Profit: Apple's gross profit has shown consistent growth year on year, indicating efficient cost management and a profitable business model.
• Net Income: Apple's net income has also displayed consistent growth, reflecting a healthy bottom line and sustained profitability.
• Profit Margins: Both the gross profit margin and net profit margin have remained consistent or increased over the years, demonstrating Apple's ability to maintain strong profitability.

From the income statement analysis, we can conclude that Apple Inc. appears to be a great business based on its consistent revenue growth, increasing net income, and competitive profit margins.

Case Study: Facebook Inc. Let's now analyze the income statement of Facebook Inc. using fundamental analysis:

• Revenue: Facebook's revenue has shown consistent growth over the past five years, indicating a strong and expanding user base.
• Net Income: Facebook's net income has also displayed consistent growth, highlighting its ability to monetize its platform effectively.
• Profit Margins: Both the gross profit margin and net profit margin for Facebook have remained consistent or increased, surpassing industry averages. This indicates a competitive advantage and strong profitability.

Based on the income statement analysis, Facebook Inc. appears to be a great business with consistent revenue growth, increasing net income, and industry-leading profit margins.

Understanding growth companies Growth companies, particularly in the technology sector, often prioritize revenue growth over immediate profitability. These companies may experience losses initially as they invest heavily in research and development and customer acquisition. However, their potential for future profitability lies in their rapid revenue growth.

Case Study: Amazon and Tesla Companies like Amazon and Tesla are examples of growth companies that have experienced losses in their initial years but exhibited rapid revenue growth. These companies prioritize market expansion and establishing a competitive edge over short-term profitability. Investors often consider revenue growth as a key indicator of their potential success.

Assessing growth companies When evaluating growth companies, investors should focus on revenue growth rates exceeding 25% annually, indicating their ability to penetrate new markets and increase their customer base. While profitability may not be immediate, consistent revenue growth suggests long-term potential.

Recap of income statement analysis

 In summary, when analyzing a company's income statement, keep the following points in mind:

• Look for consistent or increasing revenue and net income over time.
• Assess the company's ability to control costs through the gross profit margin and net profit margin.
• Compare profit margins with industry averages to evaluate competitiveness.
• Consider growth companies' revenue growth rates, even if short-term profitability is not yet achieved.

By analyzing the income statement, investors gain a deeper understanding of a company's revenue generation, cost management, and profitability. This knowledge enables them to make informed decisions and build a strong investment portfolio. Remember to consider the income statement alongside other financial statements, such as the balance sheet and cash flow statement, for a comprehensive analysis of a company's financial health.

The balance sheet is a financial statement that provides valuable insights into a company's financial strength and stability. It allows us to assess how much a company owns (assets) and how much it owes (liabilities). Understanding the balance sheet is crucial because it reveals whether a company is financially sound and capable of weathering economic downturns or financial crises.

Assets:

• • • Current Assets: These are assets that a company owns and can convert to cash within the next three months. Examples include cash in the bank, short-term investments, inventory, and accounts receivable (money owed by customers). Current assets are important indicators of a company's liquidity and ability to meet short-term obligations.

    • Long-Term Assets: These are assets that take more than three months to convert into cash. They include property, plant, and equipment, accumulated depreciation, goodwill, intangible assets, and other long-term investments. Long-term assets represent a company's ability to generate future income and its overall value.

• Liabilities:

• • • Current Liabilities: These are obligations that a company must settle within the next three months. Examples include accounts payable (money owed to suppliers), accrued liabilities, and short-term debt. Current liabilities represent a company's short-term financial obligations and its ability to meet its immediate payment requirements.

    • Long-Term Liabilities: These are obligations that extend beyond three months and are usually paid off over an extended period. They include long-term debt, long-term bank loans, and deferred tax liabilities. Long-term liabilities provide insights into a company's long-term financial obligations and its ability to manage debt over time.

• Shareholders' Equity:

• • Shareholders' equity represents the residual interest in the company's assets after deducting liabilities. It is the value that remains for shareholders if all the company's debts are paid off. Shareholders' equity reflects the company's net worth and the value that shareholders hold in the business.

1 - Current Ratio:

The current ratio is calculated by dividing current assets by current liabilities. It measures a company's ability to cover its short-term liabilities with its short-term assets.

A current ratio greater than 1 indicates that the company has more assets than liabilities in the short term, which is considered favorable and indicates a financially stable company.

2 - Debt-to-Equity Ratio:

The debt-to-equity ratio is an important metric that assesses how a company finances its operations. It compares the total liabilities of the company to its total equity. A debt-to-equity ratio below 1 indicates that the company has more equity than debt, which is considered safer and more conservative. However, it is crucial to consider industry norms and compare the company's ratio to its competitors.

For example, let's take the case of Apple, one of the leading technology companies. Apple's debt-to-equity ratio is one of the lowest among its peers, such as Amazon, Facebook, and Netflix. This indicates that Apple relies less on debt financing and has a strong equity base. Comparing a company's debt-to-equity ratio with industry benchmarks and analyzing its trends over time can provide valuable insights into its financial stability.

3  - Debt Servicing Ratio:

The debt servicing ratio measures the company's ability to meet its interest payment obligations. It is calculated by dividing the net interest expense by the cash flow from operations. A debt servicing ratio below 30% is generally considered favorable, as it indicates that the company is using a reasonable portion of its cash flow to cover its interest expenses.

To calculate the debt servicing ratio, we can refer to the income statement for the net interest expense and the statement of cash flows for the cash flow from operations. For example, let's consider 3M, a renowned multinational company. The net interest expense of 3M is $322 million, and the cash flow from operations is $6,240 million. Dividing the net interest expense by the cash flow from operations yields a debt servicing ratio of approximately 5%. This ratio is significantly below the desirable threshold of 30%, indicating that 3M has a strong ability to manage its interest payments.

Analyzing the balance sheet and assessing financial ratios allows us to gain valuable insights into a company's financial health and stability. By understanding the debt-to-equity ratio, we can evaluate how a company finances its operations and compare it to industry peers. Additionally, examining the debt servicing ratio helps us gauge a company's ability to manage its interest expenses. These analyses, when combined with other financial indicators, aid investors and analysts in making informed decisions about investing in a company. Remember, it is important to consider these ratios in the context of the company's industry and compare them over time for a comprehensive assessment.

Why Should We Focus on Cash Flow Statements?

First and foremost, let's settle the question: why should we focus on cash flow statements? For investors, if there's only one financial statement to analyze, it's the cash flow statement. Why is this so? Because it reveals the real deal, the actual cash coming into and going out of the company. Remember, even though a business might report impressive revenues or profits, that doesn't guarantee cash has indeed entered the business. A transaction might be recorded as a sale, thus profit, but if the customer doesn't pay, the company is left with empty pockets. So, which is more critical? A recorded profit or the actual collection of cash? Most would agree that cash collection is more valuable. Hence, the importance of the cash flow statement.

What are the Parts of the Cash Flow Statement?

So, what exactly does a cash flow statement consist of? Divided into three sections, it includes:

• Cash flow from operations

• Cash flow from investing

• Cash flow from financing

Each section tells its unique story about the company's financial health. Let's take a closer look at each.

What is Cash Flow from Operations?

Cash flow from operations indicates how much cash has entered or left the company due to its business activities. This information is crucial as it shows whether the company's operations are generating cash flow. In other words, it shows if the company is not just profitable on paper but in actual cash terms too.

Investors like Warren Buffett prefer to invest in companies that generate consistently positive and increasing cash flow from operations. They argue that while increasing profits are good, what matters more is whether the company is generating more cash each year. However, this isn't always consistent for certain businesses such as banks, commodity companies, and property developers due to the nature of their operations.

How do Banks, Commodity Companies, and Property Developers differ?

For these types of businesses, their cash flow from operations isn't always consistent, and sometimes, it may even be negative in certain years. But this inconsistency isn't necessarily a sign of poor financial health. It's simply a reflection of the nature of their business.

For instance, consider a property developer. The development process involves several stages, many of which require significant cash outlays. For the first few years, the company might experience negative cash flow as it purchases land, builds properties, and invests in marketing. However, once the properties are complete and start selling, the company could then experience positive cash flow. As a result, the cash flow from operations for these types of businesses is not consistent.

What is Cash Flow from Investing?

Cash flow from investing reflects the cash that goes out of the company as it invests in equipment, machinery, outlets, offices, or even other companies. When a company does this, money leaves the company, leading to a negative cash flow from investing.

However, a negative figure isn't necessarily a bad thing. It simply indicates the company is making investments or buying assets - an activity often referred to as capital expenditure or CapEx. Conversely, if the company sells an asset, cash comes in, resulting in a positive cash flow from investing. Thus, this section merely shows the movement of cash due to the company's investments.

What is Cash Flow from Financing?

Lastly, cash flow from financing pertains to the company raising or repaying money. A company can raise money in two ways: by taking on debt or by selling new shares.

When a company borrows money or sells bonds to investors, there is a cash inflow. While this might sound great, it's crucial to understand why the company is raising money. If it's to cover losses or repay other debts, that's a red flag. On the other hand, if it's to expand the business and increase cash flow from operations, it can be a positive sign.

The other method, selling new shares, also brings cash into the company. However, while this increases the company's cash, it can dilute the earnings per share, as there are now more shareholders to share the profits with. In general, investors don't favor companies selling new shares unless the company can use the raised funds to grow the business significantly.

Why is Paying Back Loans or Buying Back Shares Important?

On the other hand, when a company repays its loans, cash leaves the company, and this is considered a cash outflow. Similarly, if a company buys back its shares, it also results in cash outflow. However, these actions are generally viewed positively. Repaying loans is a clear sign of financial stability, while buying back shares reduces the number of outstanding shares, increasing the worth of each remaining share.

Why is Cash Flow from Operations the Most Important?

Out of the three parts of the cash flow statement, cash flow from operations is arguably the most significant. It indicates whether the company is consistently generating more and more cash from its business, a vital factor for its survival and growth.

For instance, let's take a look at Facebook's financial statements on MorningStar. You'll see that the cash flow from operations for the last five years is consistently positive and increasing. This growth is a strong sign of a financially healthy company that can potentially provide good returns for its investors.

In summary, understanding cash flow statements is crucial for sound investing. It provides a clear picture of how cash is flowing in and out of a company, helping you make informed decisions about your investments. Remember, the most successful investors aren't those who focus solely on a company's profits. Instead, they pay attention to the company's ability to generate cash, a metric best shown in the cash flow statement.

The Significance of Net Cash Provided by Operations

In financial jargon, 'Net Cash Provided by Operations' might sound like a mouthful, but it's just accountant-speak for the money a business makes from doing its usual work. Imagine you run a bakery - the money you make from selling your scrumptious cakes and pastries is your net cash from operations.

In the financial world, Facebook stands as an excellent example of increasing net cash provided by operations. Over five years, their operational cash flow has grown from four billion Euros to an impressive twenty-four billion. It's like your bakery started by selling 100 cakes a day, and five years later, you're selling 600! That's an unmistakable sign that your bakery is booming, and people can't get enough of your baked goods. In the same way, Facebook's consistent growth in operational cash flow suggests it's a company doing very well and potentially worth investing in.

Decoding Negative Cash Flow from Investments

Sometimes, in the financial statements of a company, you might see that the cash flow from investments is negative. But, contrary to what you might think, negative doesn't always mean bad news. It's like spending money to buy a bigger oven for your bakery. While your bank balance might take a hit, the larger oven means you can bake more cakes faster and increase your earnings in the future. In company terms, a negative cash flow from investments means they're spending money to grow - like acquiring another firm, buying new equipment, or launching a new product line.

Making Sense of Negative Cash Flow from Financing

When you spot a negative figure in the cash flow from financing section, it's not a reason to panic. Financing is just a fancy term for how a company gets the money it needs to operate. It's like getting a loan to start your bakery. If your bakery is doing well and you start paying back your loan, that's a good thing, even though it means your cash in hand might be decreasing. Similarly, when a company has negative cash flow from financing, it could be because they're paying back loans or buying back shares – both positive signs of a healthy business.

Why Increasing Cash Flow from Operations is Crucial

If there's one key takeaway from financial analysis, it's this: Consistent increase in cash flow from operations is vital. It's as if your bakery started with one outlet and then opened up a new one every year. That shows your bakery chain is growing, which is fantastic news for any potential investors.

What is Free Cash Flow?

Free Cash Flow (FCF) is what a company has left after paying for all its expenses, including investments. It's like your bakery earnings after you've paid for all the flour, eggs, sugar, and even that new oven. Seeing a consistently positive and growing FCF is excellent because it shows the company is making more than it spends, which means more potential profits for shareholders.

Calculating the Health of a Company's Cash Flow

If you want to figure out whether a company's cash flow is healthy, there's a simple trick. Divide the Free Cash Flow by the company's total sales revenue. If the answer is more than 5%, then the company is doing well. It's like if your bakery earned $10,000, and after paying for all the expenses, you're left with $600. That's a 6% cash flow, which means your bakery is baking up a storm!

Earnings Per Share (EPS) and Why They're Important

EPS is like splitting your bakery profits per cake sold. If your bakery made $1,000 in profit and sold 500 cakes, your earnings per cake (or EPS) would be $2. If that number keeps increasing, it's a good sign your bakery is becoming more profitable.

However, keep in mind that just like a clever baker could use a smaller slice to make it seem like they're serving more cake, companies can manipulate EPS by reducing the number of shares. So, when you see a company's EPS increasing, make sure it's due to increasing profits and not decreasing shares.

Price to Earnings Ratio (P/E Ratio) in Investment Decisions

The P/E ratio is the price of one share divided by the company's EPS. It's like figuring out how much each slice of your profit cake costs. If the price per slice seems too high compared to how much profit each slice represents, maybe it's not a great deal.

The Role of Return on Equity (ROE)

ROE is a measure of how effectively a company uses the money shareholders invest. It's like if your bakery took all the money investors gave and turned a significant portion into profits, you're providing a good 'return' on their 'equity' or investment. Anything above a 12% ROE consistently is a well-performing business, and anything above 15% is fantastic!

Fundamental Analysis Summary:

A process of evaluating a company's financial health and performance by examining its fundamental factors. Helps investors determine the intrinsic value of a business and make informed investment decisions.

Income Statement:

Reveals a company's financial performance over a specific period. Shows revenues, expenses, and net profit or loss. Helps understand how effectively the company is making money.

Real Example:

Apple Inc.'s income statement shows consistent upward trend in revenue, gross profit, and net income, indicating strong sales growth, efficient cost management, and sustained profitability.

Income Statement Analysis

A comprehensive analysis of a company's financial health, by examining its revenue generation, cost management, and profitability.

Analyzing the Balance Sheet

The balance sheet provides insights into a company's assets, liabilities, and shareholders' equity. It is important to analyze these components to assess a company's liquidity, debt, and equity. Ratios such as the current ratio, debt-to-equity ratio, and debt servicing ratio can be used to analyze the balance sheet.

Cash Flow Statements

Cash flow statement reveals actual cash coming into and going out of the company. It is divided into three sections: cash flow from operations, investing, and financing. It is important to consider these in context of the company's industry and compare them over time.

Cash Flow from Operations

Cash flow from operations reflects the cash that goes in and out of the company due to its core business activities. It is the most important part of the cash flow statement, as it indicates whether the company is consistently generating more and more cash.

The Significance of Net Cash Provided by Operations

Net cash provided by operations is money a business makes from its usual work. Facebook's increasing net cash from operations is a sign of a healthy company.

Decoding Negative Cash Flow from Investments

Negative cash flow from investments means a company is spending money to grow.

Making Sense of Negative Cash Flow from Financing

Negative cash flow from financing could mean a company is paying back loans or buying back shares.

Why Increasing Cash Flow from Operations is Crucial

Consistent increase in cash flow from operations is vital for sound

Summary:

Free Cash Flow (FCF) is a company's earnings after expenses, and a healthy FCF is more than 5% of total sales revenue. Earnings Per Share (EPS) is profits per unit sold, but can be manipulated. Price to Earnings Ratio (P/E Ratio) is the price of one share divided by the EPS. Return on Equity (ROE) measures how effectively a company uses investor money, with 12-15% being good-to-fantastic.