Fundamental analysis is the process of studying the financial and economic health of a security or a company in order to make informed investment decision making. This involves an in-depth and thorough examination of the accounting books and interpreting the results. This involves looking at and analyzing the financial statements of a company. Financial statements can be intimidating at first, especially for starters with little accounting background. Below is a brief guide on the four most important financial statements.
1. Financial Statement – Balance Sheet
The balance sheet, otherwise known as the statement of financial position, shows the financial standing of a company. It’s a snapshot in time of a company’s financial health. This financial statement is organized into three sections, including assets, liabilities, and equity.
Also, remember that assets = liabilities + equity.
Assets Section on a Balance Sheet
The assets section on a balance sheet includes the totals of all types of assets. Assets are the property and items that a company owns. There are three main types of assets. They include current assets, fixed assets, and intangible assets. Current assets are cash and other assets that can easily be converted into cash within a year. Current assets include cash equivalents, marketable securities, inventory, account receivables, and other liquid assets. Fixed assets are property plants and equipment that cannot be easily liquidated or sold. Intangible assets are not physical items such as patents, goodwill, company recognition, trademarks, copyright, and other similar things.
Liabilities Section on a Balance Sheet
Liabilities are debts and obligations a company owes to its creditors and customers. Every company incurs liabilities at one point in its operations. They can be broken down into current liabilities and long-term liabilities. Current liabilities are those debts and obligations which are due within a year. Examples include accounts payable, customer deposits, interest payable, the current due portion of long-term debt and other short-term debt. Whereas, long-term liabilities are those that are due after one year. They include multi-year loans, bonds payable, deferred revenue, pension obligations, mortgages, and other long-term debt.
The important thing to remember for company health analysis is that the company should be able to meet its short-term and long-term obligations in a timely manner. If a company is unable to meet these obligations, it has a risk of becoming insolvent and could go bankrupt.
Equity Section on a Balance Sheet
Equity is the owner’s interest or residual claim in the business after deducting the company’s liabilities from its total assets. The amount of equity in the balance sheet will give you an idea of the net worth of a company or its value to its owners. Though, often it’s merely just book value in the balance sheet, especially for publicly traded companies (i.e. stocks).
2. Financial Statement – Income Statement
The income statement is perhaps one of the most common financial statements that you will be encountering in fundamental analysis. An income statement encompasses the organization’s revenue and expenses together with its gains/profits and losses. Unlike the balance sheet that’s a snapshot of financial health in time, the income statement is more like a change in financial health over a specific time period. The standard is that there are monthly, quarterly, and annual income statements. However, technically a company can create an income statement for any time period.
For non-accountants, revenue and income may seem the same but they are not. Let’s look at the definitions of each.
Revenue
Revenue is the gross amount that a company earns from its principal operations such as a bakery selling bread and pastries. It includes all the funds that are coming in from these operations without accounting for any expenses.
Expenses
Expenses are the costs of conducting business. Some examples include the cost of goods sold, administrative costs, legal fees, insurance costs, office supplies, rent, repair, maintenance costs, and many more. When you subtract all expenses from the revenue you arrive at the net profit or net income.
Net Income
Net Income is the net of everything or revenue minus all expenses, including taxes.
3. Financial Statement – Cash Flow Statement
Where did the organization’s cash and cash equivalents go? That’s what you are likely to see in the statement of cash flow (or cash flow statement). It’s derived from the balance sheet and income statement. It shows how each balance sheet account and income affects a company’s cash flow.
When prepared using the direct method, the cash flow statement is divided into operating, investing and financing activities. This way you’re able to determine which type of activity generates or consumes the most cash.
4. Financial Statement – Statement of Changes in Equity
If you are interested in how much of the income a shareholder retains in the company, this is the place to be. The Statement of changes in equity describes the change in owner’s equity over an accounting period. The main things included in this statement are net income or losses that will be added or subtracted from the equity, any dividend payments to owners, as well as the previous and new shareholder equity balance.
This statement is not usually disclosed in the monthly financial statements but it is still worth looking at when doing fundamental analysis.