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FUNDAMENTAL
ANALYSIS:
PART
4
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14 Aug 2013 | www.pinoyinvestor.com

INTRODUCTION TO FUNDAMENTAL ANALYSIS: PART 4

(by Investopedia.com and PinoyMoneyTalk.com)

In Part 3, we discussed the Quantitative factors involved in analyzing a stock

investment. We also took on the first two financial statements: the Income Statement and the
Balance Sheet. Here in Part 4, well take a look at the third financial statement, the Cash
Flow Statement, as well as a primer on financial statement analysis and valuation.

The Cash Flow Statement

The cash flow statement shows how much cash comes in and goes out of the company
over the quarter or the year. At first glance, that sounds a lot like the income statement in
that it records financial performance over a specified period. But there is a big difference
between the two.
What distinguishes the two is accrual accounting, which is found on the income
statement. Accrual accounting requires companies to record revenues and expenses when
transactions occur, NOT when cash is exchanged.
At the same time, the income statement often includes non-cash revenues or expenses,
which the statement of cash flows does not include.
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Just because the income statement shows net income of $10 does not means that cash on
the balance sheet will increase by $10. Whereas when the bottom of the cash flow statement
reads $10 net cash inflow, that's exactly what it means. The company has $10 more in cash
than at the end of the last financial period. You may want to think of net cash from operations
as the company's "true" cash profit.
Because it shows how much actual cash a company has generated, thestatement of cash
flows is critical to understanding a company's fundamentals. It shows how the company is
able to pay for its operations and future growth.
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.
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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.
1. 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.
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Watch out for a widening gap between a company's reported earnings and its cash
flow from operating activities. If net income is much higher than cash flow, the
company may be speeding or slowing its booking of income or costs.
2. 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.
3. 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.

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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 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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Financial Ratio Analysis

The figures appearing on the companys financial statements are not enough to present a
complete story of the overall financial performance of the business. To understand the
companys financial health, the investor must conduct financial analysis and compare the
companys financial ratios with standards, goals, or industry averages.
There are several types of financial statements analysis. Among them are analysis
related to breakeven point, profitability, liquidity, activity or asset efficiency, and debt or
leverage. These ratios are briefly summarized and explained below.

TABLE 1: BREAK-EVEN ANALYSIS

Financial Ratio

Formula

What It Means

Fixed Costs
Contribution Margin per Unit
Breakeven
Point

where:
Contribution Margin per Unit =
Revenue per Unit Variable
Expenses per Unit

Important for young companies, this is

the point at which costs or expenses
and revenues are equal. At breakeven
point, the company has neither net
loss nor gain. Any units above the
breakeven point will generate a net
income for the business.

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TABLE 2: PROFITABILITY ANALYSIS

Financial Ratio

Gross Margin

Net Profit
Margin

Return on
Equity (ROE)

Formula

What It Means

____Gross Profit __t

Net Revenues or Sales

Compares the companys total sales

with the cost of those sales. An
increase in gross margin may result
from higher sales, lower cost of goods
sold, an increase in the proportionate
volume of higher margin products, or
any combination of the above. A
business with a higher Gross Margin
compared to a similar business
means it has higher profits that can
cover for other business expenses.

_____Net Income
e
Net Revenues or Sales

The total profit per unit of sales after

all costs and expenses have been
deducted. A higher Net Profit Margin
means a company has better
profitability.

______Net Income
e
Average Stockholders Equity

The amount of net income returned

as a percentage of shareholders

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equity. Return on equity measures a

corporation's profitability by
revealing how much profit a company
generates with the money
shareholders have invested.

DuPont Return
on Equity
(ROE)

Related to ROE,assets are measured

at their gross book value rather than
at net book value in order to produce
a higher ROE. If ROE is
unsatisfactory, the DuPont analysis
helps locate the part of the business
that is underperforming.It is also
known as "DuPont identity".

Return on
Assets (ROA)

___Net Income e
Average Assets

An indicator of how profitable a

company is relative to its total assets.
ROA shows how efficientlyassets are
being used to generate earnings.

Earnings per
Share (EPS)

___Net Income___s
Weighted Average Number of
Common Shares Outstanding

The amount of earnings per each

outstanding share of a company's
stock.

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TABLE 3: LIQUIDITY ANALYSIS

Financial Ratio

Working
Capital

Current Ratio

Quick Ratio

Formula

What It Means

Current Assets Current

Liabilities

An indicator of whether the company

will be able to meet its current
obligations. The greater the amount
of working capital, the more likely
the business will be able to make its
payments on time.

Current Assetss
Current Liabilities

Indicates the company's ability to pay

short-term liabilities with short-term
assets (cash, inventory, receivables).
A ratio under 1 suggests that the
company would be unable to pay off
its obligations if they came due at
that point. A 2:1 ratio is a standard
in most industries, although this is
not the case in all industries.

Cash + A/R + Short-Term Investments

Current Liabilities

A more stringent ratio compared to

the Current Ratio, which excludes
inventory in testing the ability of the

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company to pay short-term liabilities

with its highly-liquid assets.

TABLE 4: ACTIVITY OR EFFICIENCY ANALYSIS

Financial Ratio

Inventory
Turnover

Days Sales in
Inventory

Formula

What It Means

Cost of Goods Sold

Average Inventory

Shows how many times a company's

inventory is sold and replaced over a
period. Must be compared against
industry averages. A low turnover
implies poor sales and, therefore,
excess inventory. A high ratio implies
either strong sales or ineffective
buying. High inventory levels are
unhealthy because they represent an
investment with a zero rate of return.

____365 days
s
Inventory Turnover

The average number of days it takes

to sell the average inventory during
the year. Must be compared with the
industry average and the companys
historical ratio.

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Accounts
Receivable
Turnover

Days Sales in
Accounts
Receivables

Asset Turnover

___Net Credit Sales

s
Average Accounts Receivable

The number of times per year that

the accounts receivables are
converted to cash. A high ratio
implies that a company either
operates on a cash basis or its
extension of credit and collection of
accounts receivable is efficient. A low
ratio implies the need to re-assess
credit policies to ensure the timely
collection of imparted credit that is
not earning interest for the firm.

___365 days s
A/R Turnover

The average number of days it takes

to collect the average amount of
accounts receivables during the year.
Compare with the industry average
and the companys historical ratio.

Net Sales
Total Assets

Measures a firm's efficiency at using

its assets in generating sales or
revenue. The higher the number, the
better.
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TABLE 5: DEBT OR LEVERAGE ANALYSIS

Financial Ratio

Debt Ratio

Debt-to-Equity
Ratio

Interest
Coverage Ratio

Formula

What It Means

Total Liabilities
Total Assets

Shows what proportion of debt a

company has relative to its assets.
The ratio gives an idea to the
leverage of the company along with
the potential risks it faces in terms of
its debt.

__Total Liabilities s
Stockholders Equity

Indicates what proportion of equity

and debt the company is using to
finance its assets. A high debt/equity
ratio generally means that a company
has been aggressive in financing
growth with debt. This can result in
volatile earnings as a result of the
additional interest expense.

Earnings before Interest &Taxes

Interest Expense

Shows how easily a company can pay

interest on outstanding debt. The
lower the ratio, the more the
company is burdened by debt

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expense. When a company's interest

coverage ratio is 1.5 or lower, its
ability to meet interest expenses may
be questionable.

A Brief Introduction 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 (DCF) 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
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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.The cash flow
model, however, looks at the cash that can be paid to shareholders after all expenses,
reinvestments, and debt repayments have been made.
Conceptually, they are all the same, as it is the present value of these streams that are
taken into consideration.
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
On top of the financial ratios above, there are what we call valuation ratios.These help us
gain some understanding of the companys value (i.e. whether it is undervalued or
overvalued).The most well-known of these are price-to-earnings and price-to-book. The latter
compares the companys price per share to its book value.
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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 generally 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.

TABLE 6: RATIO VALUATION

Financial Ratio

Price-toEarnings

Formula

What It Means

Stock Price
EPS

A ratio of a company's current share

price compared to its per-share
earnings.Also known as "price
multiple" or "earnings multiple"
because it shows how much investors
are willing to pay per dollar of the
companys earnings. In general, a
high P/E suggests that investors are
expecting higher earnings growth in
the future compared to companies
with a lower P/E. Must be compared
with P/E ratios of other companies in
the same industry or against the
company's own historical P/E.
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Price-to-Book

Compares a stock's market value to

its book value. A lower ratio could
mean that the stock is undervalued.
However, it could also mean that
Stock Price
s something is fundamentally wrong
Total Assets - Intangible assets - with the company. As with most
Liabilities
ratios, this varies by industry. This
ratio also gives some idea of whether
you're paying too much for what
would be left if the company went
bankrupt immediately.
Credits: Investopedia.com and PinoyMoneyTalk.com

This wraps up the Introduction to Fundamental Analysis series of the PinoyInvestor Academy. We
hope Part 4 and its loaded information taught you how to use financial ratios so that ultimately, you
can make smarter investment decisions!

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