The Booklet is an excellent resource for
basic financial information about Investment & Security Analysis. It
explains financial concepts in a straightforward and
easy-to-understand way.
…….Ejaz
Alam Khan
INTRODUCTION
INVESTMENT RISK
Risk
is an inherent part of investing. Generally, investors must take greater risks
to achieve greater returns. Those who do not tolerate risk very well have a
relatively smaller chance of making high earnings than do those with a higher
tolerance for risk.
In order to understand the different types of risk, we
have broken them down into these levels:
Personal Risks
Company Risks
Market Risks
National and
International Risk
PERSONAL RISKS
This category of risk deals with the personal level of
investing. The investor is likely to have more control over this type of risk
compared to others.
Timing risk: This is the risk
of buying the right security at the wrong time. It also refers to selling the
right security at the wrong time. For example, there is the chance that a few
days after you sell a stock it will go up several rupees in value. There is no
surefire way to time the market.
Tenure risk: This is the risk of losing money while holding onto a
security. During the period of holding, markets may go down, inflation may
worsen, or a company may go bankrupt. There is always the possibility of loss
on the company-wide level, too.
COMPANY RISKS
There are two common risks on the company-wide level.
The first, financial risk is the danger that a company will not be able to
repay its debts. This has a great effect on its bonds, which finance the
company's assets. The more assets financed by debts (i.e., bonds and money
market instruments), the greater the risk. Studying financial risk involves
looking at a company's management, its leadership style, and its credit
history.
Management
risk: Management risk is the risk that a company's management may run the
company so poorly that it is unable to grow in value or pay dividends to its
shareholders. This greatly affects the value of its stock and the
attractiveness of all the securities it issues to investors.
MARKET RISKS
Fluctuation
in the market as a whole may be caused by the following risks.
Market risk: Market risk is
the chance that the entire market will decline, thus affecting the prices and
values of securities. Market risk, in turn, is influenced by outside factors
such as embargoes and interest rate changes see Political Risk below.
Liquidity risk:
Liquidity
risk is the risk that an investment, when
converted to cash, will experience loss in its value.
Interest rate
risk: Interest rate risk is the risk that interest rates will rise, resulting
in a current investment's loss of value. A bondholder, for example, may hold a
bond earning 6% interest and then see rates on that type of bond climb to 7%.
Inflation risk:
Inflation
risk is the danger that the amount one
invests will buy less in the future because prices of consumer goods rise. When
the rate of inflation rises, investments have less purchasing power. This is
especially true with investments that earn fixed rates of return. As long as
they are held at constant rates, they are threatened by inflation. Inflation
risk is tied to interest rate risk, because interest rates often rise to
compensate for inflation.
Exchange rate
risk: Exchange
rate risk is the chance that a nation's
currency will lose value when exchanged for foreign currencies.
Reinvestment
risk: Reinvestment
risk is the danger that reinvested money
will fetch returns lower than those earned before reinvestment. Individuals
with dividend-reinvestment plans are a group subject to this risk. Bondholders
are another.
NATIONAL
AND INTERNATIONAL RISKS
National
and world events can have profound effects on investment markets.
Economic risk: Economic risk is the danger that the economy as a whole will perform
poorly. When the whole economy experiences a downturn, it affects stock prices,
the job market, and the prices of consumer products.
Industry risk: Industry risk is the chance that a specific industry will perform
poorly. When problems plague one industry, they affect the individual
businesses involved as well as the securities issued by those businesses. They
may also cross over into other industries. For example, after a national
downturn in auto sales, the steel industry may suffer financially.
Tax risk: Tax risk is the danger that rising taxes will make investing
less attractive. In general, nations with relatively low tax rates. Businesses
that are taxed heavily have less money available for research, expansion and
even dividend payments. Taxes are also levied on capital gains, dividends and
interest. Investors continually seek investments that provide the greatest net
after-tax returns.
Political risk:
Political
risk is the danger that government
legislation will have an adverse effect on investment. This can be in the form
of high taxes, prohibitive licensing, or the appointment of individuals whose
policies interfere with investment growth. Political risks include wars,
changes in government leadership, and politically motivated embargoes.
ANNUAL AND QUARTERLY REPORTS
In
the following, we will look at the information available in corporate reports.
We will cover the following topics:
What are an Annual
Report and Why Is It Useful to Investors?
Required Information
How to Obtain
Annual Reports
Quarterly and
Other Financial Reports
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WHAT IS AN
ANNUAL REPORT AND WHY IS IT USEFUL TO INVESTORS? |
A
Company is required by law to provide its shareholders with information about
its operations. An annual report satisfies this obligation. The
information in an annual report shows the company finances. It is extremely
useful to investors because it allows them to use their own judgment on how
well the company is doing and forecast its future earnings and dividends. For
an investor, this information is critical for making investment decisions. You
can also read the Chairman's letter about the company's future goals. Use
caution with these letters since the author is company representative. You
may want to look at how accurate this letter has been in the past to give you
an idea how much you can trust it. Read
below here to find out what is included in an annual report. |
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An
annual report is a brief profile on the health of a company. Here is what
comprises an annual report: |
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Keep
in mind that the public relations department of the company produces the
annual report. The report should be very accurate with all the information
described in the best possible manner. |
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Annual
reports are mailed automatically to all shareholders of record. To obtain the
annual report for a company in which you do not own shares, call the public
relations (or shareholder relations) department of the company. You may also
look on the company web site, or search the Internet. There are several
sources on the Internet providing information on public companies. You can
search the database at http://www.kse.net.pk.
Simply keying in the stock's symbol will provide you with the needed
information. |
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QUARTERLY
AND OTHER FINANCIAL REPORTS |
Besides
the annual report, companies also provide quarterly reports. |
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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. |
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Statistical Supplements are reports of larger corporations as well. They
provide financial information, such as statement data and key ratios, which
can be dated back ten to twenty years. One should contact the company's
corporate secretary to get these Statistical supplements. These reports are also available with
brokerage houses providing financial consultancy services. This
concludes our tutorial on corporate financial reports. |
UNDERSTANDING COMPANY EARNINGS
In
this tutorial, you will learn about corporate earnings and why they are
important to an investor. You will learn what goes into corporate earnings and
how to use earnings information to make a decision about investing in a
corporation. You will progress through the following topics:
What Are Company
Earnings?
Why Are Earnings
Important To You as an Investor?
What Makes Up
Corporate Earnings?
Where Do You Find
Corporate Earnings Information?
How Do You Use
Earnings Information To Make An Investment Decision?
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WHAT ARE COMPANY
EARNINGS? |
You
go into business to make money. Unless an organization is a not-for-profit
enterprise, its goal is to make money for the owners. In order to make money,
the business must have income to pay its employees, utility bills, costs of
production and other operating expenses. If a company has cash left over
after paying its expenses, it has earnings. Earnings are a company's net
profit. The
nature of a business defines how it makes earnings. Two sources of company
earnings are income from sales of goods or services and income from
investment. For example, a manufacturer produces goods for sale to its
customers. A bank sells depository services to its customers. All businesses
generate income by providing either goods or services to customers. Another
source of income is investment. Investments generate income for businesses
and individuals from either interest on loans, dividends from other
businesses, or gains on the sale of investment property. Company earnings are the sum of income from sales or investment after paying its
expenses. Sounds
simple enough, but what does this have to do with you? |
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WHY ARE EARNINGS
IMPORTANT TO YOU AS AN INVESTOR? |
Remember
from the previous lesson that people go into business to make money. Well, if
you invest in a company's stock, you gain an undivided share of the company.
Typically, when a company earns more money, shareholders do as well.
Meanwhile, if you invest in bonds of the company, the company uses part of its
earnings to repay interest and principal on the bonds. The more earnings the
company has, the more secure you can be that the company will make your
interest payments. So, company earnings are important to you because you make
money when the business you invest in makes money When a company you own
stock in has positive earnings, it benefits you in several ways.
In
any case, earnings are important to you because they provide a company with
capital to make money for you as an investor. |
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WHAT
MAKES UP CORPORATE EARNINGS? |
Income
from sales and investments produce earnings. Before
a company can sell its product or service, it incurs expenses to produce
them. These expenses may include cost of materials, labor, market research,
marketing, sales and distribution and overhead. Before a company can show a
profit, it must first settle the costs of doing business. The
way in which a business conducts its operations is an important element to
understand when evaluating a company's earnings. Companies that are devoting
significant resources to creating a new product may have a relatively weak
earnings now. But, if that new product catches on, profits could quickly rise
and the earnings may begin to soar. Meanwhile, companies that have great
earnings now, but are not investing any money to ensure that their business
success will continue, may have significant problems in the future. When
evaluating corporate earnings you should not only look at the income sources,
but the expenses as well. They can reveal the company's long-term strategy
for making money, or uncover potential inefficiency or mismanagement. |
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WHERE
DO YOU FIND CORPORATE EARNINGS INFORMATION? |
The
best place to learn about company earnings is the corporate annual report.
The annual report contains information on the company philosophy and its
position in the marketplace. It also contains audited financial statements.
These tell you all about the company's financial operations. You can obtain
an annual report directly from the company's public relations department or on
the company’s web. To
find information about the company's earnings, you should study the
"income statement" and "balance sheet." The income
statement shows the sources of a company's income, production costs and other
expenses. The balance sheet shows the company's overall financial strength
and potential for future growth. |
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HOW DO YOU USE EARNINGS
INFORMATION TO MAKE AN INVESTMENT DECISION? |
How
you use this information depends upon your investment goals. If you are an
income investor, you probably want to invest in a company that is paying
dividends. If you are looking for long-term growth, dividends may not be as
important to you. The "financials" will show you whether a company
is oriented for income, growth, or a bit of both. You can get all this
information from the financials. But you must compare the financials for
different companies in the same industry to see which has characteristics
best suited to your investment goals. |
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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
comparing earnings per share of several companies that are candidates for
your investment, here are a few things for which to look. Companies:
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This
concludes our brief introduction tutorial about understanding company's
earnings. By now, you should know what earnings are, how they are calculated
and why they are important to investors. You also know how to find current
earnings information.
PROFITABILITY RATIOS
Corporate
earnings are important to you as an investor. If you compare corporate earnings
of prospective investments, you will make wiser investment decisions.
Profitability ratios provide you with tools you can use to make these
comparisons.
In
this tutorial you will learn:
How Do I Use
Fundamentals To Make An Investment Decision?
What Is Ratio
Analysis?
What Can I Learn
From Profitability Ratios?
When Is An
Increase In Earnings A Loss?
How to Use
Profitability Ratios To Make Investment Decisions?
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HOW DO I 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. Performing fundamental analysis will teach you
a lot about a company, but virtually nothing about how it will perform in the
stock market. Apply this analysis on two competing companies and it becomes
clearer which is the better investment choice. In
this tutorial, you will learn to use some of the tools of the fundamental
analyst. As
an investor, you are interested in a corporation's earnings because earnings
provide you with potential dividends and growth. Companies with greater
earnings pay higher dividends and have greater growth potential. You can use
profitability ratios to compare earnings for prospective investments. Profitability ratios 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. |
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WHAT IS RATIO ANALYSIS? |
While
a detailed explanation of ratio analysis is beyond the scope of this
tutorial, we will focus on a technique, which is easy to use. It can provide
you with a valuable investment analysis tool. This
technique is called cross-sectional analysis. Cross-sectional analysis compares financial ratios of several
companies from the same industry. Ratio analysis can provide valuable
information about a company's financial health. A financial ratio measures a
company's performance in a specific area. For example, you could use a ratio
of a company's debt to its equity to measure a company's leverage. By
comparing the leverage ratios of two companies, you can determine which
company uses greater debt in the conduct of its business. A company whose
leverage ratio is higher than a competitor's has more debt per equity. You
can use this information to make a judgment as to which company is a better
investment risk. However,
you must be careful not to place too much importance on one ratio. You obtain
a better indication of the direction in which a company is moving when
several ratios are taken as a group. |
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WHAT CAN I
LEARN FROM THE PROFITABILITY RATIOS? |
The
profitability ratios include: Operating Profit Margin, Net-Profit Margin,
Return on Assets and Return on Equity. Profit Margin
measures how much a company earns relative to its sales. A company with a
higher profit margin than its competitor is more efficient. There are two
profit margin ratios. |
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Operating Profit Margin = Earnings before interest and
taxes Sales |
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Net Profit Margin = Earnings after taxes Sales |
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While
it seems as if these both measure the same attribute, their results can be
dramatically different due to the impact of interest and tax expenses.
Similarly, the next two ratios appear to be similar but they tell different
stories. As an investor, you are interested in getting a return on your
investment. So
is a company: |
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Return on Assets tells how well management is performing on all the firm's resources.
However, it does not tell how well they are performing for the stockholders. Return on Assets = Earnings after taxes Total Assets |
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Return on Equity measures how well management is doing for you, the investor because
it tell how much earnings they are getting for each of your invested amount. |
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Return on Equity = Earnings after taxes Equity |
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These
ratios are easy to calculate and the information is readily available in a
company's annual report. All you need do is review the income statement and
balance sheet to come up with the data to plug into the formulas. But,
do not neglect other income statement information that can save you from
making a costly mistake. |
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WHEN IS
AN INCREASE IN EARNINGS A LOSS? |
Sometimes
an increase in company earnings can disguise an operating loss. If a
company's operating expenses exceed its operating income, it has an operating
loss. If it also has "income" from investments and tax benefits,
this income can offset the loss and show an increase in earnings per share.
However, if these other sources of non-operating income are not recurring,
the unsuspecting investor may come to an erroneous conclusion about the
company's overall financial health. The lesson to be learned here is to
carefully scrutinize the financials especially when operating income is
negative. |
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HOW DO YOU USE YOUR
KNOWLEDGE OF PROFITABILITY RATIOS TO MAKE INVESTMENT DECISIONS? |
When
considering a company as a prospective investment you should review its
financial statements. Pay particular attention to the profitability ratios.
If you can, calculate the ratios for the same company over several successive
years to see if the company earnings are consistent, growing, or declining. Compare
your candidate's ratios to other companies in the same industry. This will
help you determine where your candidate stands in the industry. Do
not ignore other financial information on the income statement and balance
sheet. Pay particular attention to losses in income items. |
UNDERSTANDING THE BALANCE SHEET
In
this tutorial, we will learn the importance of balance sheets to you as an
investor. We will cover what they represent, how to understand them and how
they are presented. We will also provide some useful equations and an example
of a balance sheet.
The
tutorial will cover the following topics:
Understanding The
Balance Sheet
Why Should The
Balance Sheet Be Important To You?
The Basic Concept
Behind A Balance Sheet
What Are Assets?
What Are
Liabilities?
What Is
Shareholders' Equity?
Example Of A
Balance Sheet
Tying It All
Together
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UNDERSTANDING THE BALANCE SHEET |
In order to make an informed investment decision, you
should review a company's balance sheet. Let's look at what a balance sheet
entails. The balance sheet is one of the most important
financial statements of a company. It is reported to investors at least once
per year. It may also be presented quarterly, semiannually or monthly. The
balance sheet provides information on what the company owns (its assets),
what it owes (its liabilities), and the value of the business to its
stockholders (the shareholders' equity). The name balance sheet is derived
from the fact that these accounts must always be in balance. Assets must
always equal the sum of liabilities and shareholders' equity. |
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WHY SHOULD THE BALANCE SHEET BE IMPORTANT TO YOU? |
The balance sheet is the fundamental report of a
company's possessions, debts and capital invested. Before investing in any
company, an investor can use the balance sheet to examine the following:
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 company's future performance. In this
tutorial, you will learn the basic building blocks necessary to do such
analysis. Once you completely understand the balance sheet, making informed
investment decisions should be much easier for you. Read below to start understanding the basic concept
behind the balance sheet. |
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THE BASIC CONCEPT BEHIND A BALANCE SHEET |
The concept behind the balance sheet is very simple.
In order to acquire assets, a firm must pay for them with either debt
(Liabilities) or with the owners' capital (Shareholders' Equity). Therefore,
the following equation must hold true: Assets = Liabilities +
Shareholders' Equity Total Liabilities Rs.
30,000 Shareholders' Equity Rs.
50,000 Total Assets Rs.
80,000 |
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WHAT ARE ASSETS? |
Assets are economic
resources that are expected to produce economic benefits for its owners.
Assets can be buildings and machinery used to manufacture products. They can
be patents or copyrights that provide financial advantages for their holder.
Let us begin with a look at a few of the important types of assets that
exist. |
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Current assets are assets that
are usually converted to cash within one year. Bondholders and other
creditors closely monitor a company's current assets since interest payments
are generally made from current assets. They include several forms of current
assets: |
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Long-term assets are grouped into several categories.
The following are some of the common terms you will:
Remember that every company will have different
assets depending on its industry. However, it is important to know and
understand the major accounts that will appear on most balance sheets. Now,
we will talk about what the company owes to others: its liabilities. |
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Liabilities are obligations a
company owes to outside parties. They represent rights of others to money or
services of the company. Examples include 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. Both bond and stock investors scrutinize liabilities.
A company that has too many financial obligations may be in danger of going
bankrupt. In this case, both bond and stock investors usually lose. Bond
investors also must examine the type of debt that the company has issued. If
a bankruptcy does occur, there is a hierarchy of debtors. An investor will
want to ensure that he/she is high on the list to be paid before the money
runs out. Let us start our analysis of liabilities with current liabilities. |
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Current liabilities are those
obligations that are usually paid within the year, such as Accounts payable,
interest on long-term debts, taxes payable, and dividends payable. Because
current liabilities are usually paid with current assets, as an investor it
is important to examine the degree to which current assets exceed current
liabilities. The most pervasive item in the current liability
section of the balance sheet is Accounts payable. Accounts payable are debts owed to suppliers for the purchase of
goods and services on an open account. Almost all firms buy some or all of
their goods on account. Therefore, you will often see Accounts payable on
most balance sheets. |
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Long-term debt is a liability of
a period greater than one year. It usually refers to loans a company takes
out. 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.
That wraps up our short review of liabilities. You
only have one piece left of the balance sheet left to learn - Shareholders'
Equity. Remember that Assets minus Liabilities equal Shareholders' Equity. |
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Shareholders' equity 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 that are subsequently reinvested in the company. This reinvested
income is called Retained Earnings.
Now that we understand the major components, let us
move forward to examine a sample balance sheet. |
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Below you will see an example of a balance sheet and
the various components that you have been studying earlier. The most
important lesson to learn in viewing this example is that the basic balance
sheet equation holds true. Assets = Liabilities +
Shareholders' Equity The following balance sheet is arranged vertically
starting with assets and then proceeding to detail liabilities and
shareholders' equity. Note that the balance sheet gives a snapshot of the
assets, liabilities and equity for a given day. In our case, that is December
31. Often a balance sheet shows information for two successive periods as the
one below. This gives the investor a better perspective of the company's
operations by showing areas of growth. |
ABC
INDUSTRIES LIMITED
Balance
Sheet Ending December 31st
2003 2004
ASSETS
Current Assets
Cash and cash
equivalents Rs.
10,000 10,000
Accounts receivable 35,000 30,000
Inventory 25,000 20,000
Total Current Assets 70,000 60,000
Fixed Assets
Plant and machinery 20,000 20,000
Less depreciation -12,000 -10,000
Land 8,000 8,000
Intangible Assets 2,000 1,5000
TOTAL ASSETS Rs. 88,000 79,500
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Accounts payable Rs. 20,000 15,500
Taxes payable 5,000 4,000
Long-term bonds
issued 15,000 10,000
TOTAL LIABILITIES 40,000 29,500
SHAREHOLDERS' EQUITY
Common Stock 40,000 40,000
Retained Earnings 8,000 10,000
TOTAL SHAREHOLDERS' EQUITY 48,000 50,000
LIABILITIES & SHAREHOLDERS' EQUITY Rs.
88,000 79,500
As
you can see, total liabilities and shareholders' equity equals total
assets.
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TYING IT ALL TOGETHER |
You have now learned the basic construction of a
balance sheet and should have a clearer understanding of its importance. The
basic financial statement reveals what a company owns, what a company owes to
others, and the investments its owners made. It details how a company
finances its operations and what assets the company has acquired with this
financing. The key to understanding the balance sheet is in the
most basic and fundamental of all accounting equations: Assets must equal
liabilities plus shareholders' equity. All of our further balance sheet
analysis will be based upon that building block. This concludes our introductory tutorial on the
balance sheet. |
BALANCE SHEET ANALYSIS
In
this tutorial, we will look at some of the tools you can use in making an
investment decision from balance sheet information.
We
will cover the following topics here:
Why You Should
Analyze A Balance Sheet
Liquidity Ratios
Leverage
Bankruptcy
Tying It All
Together
A
thorough analysis of a company's balance sheet is extremely important for both
stock and bond investors.
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WHY YOU SHOULD ANALYZE A
BALANCE SHEET |
The
analysis of a balance sheet can identify potential liquidity problems. These
may signify the company's inability to meet financial obligations. An
investor could also spot the degree to which a company is leveraged, or
indebted. An overly leveraged company may have difficulties raising future
capital. Even more severe, they may be headed towards bankruptcy. These are
just a few of the danger signs that can be detected with careful analysis of
a balance sheet. Beyond
liquidity and leverage, the following tutorial will discuss other analysis
such as working capital and bankruptcy. As an investor, you will want to know
if a company you are considering is in danger of not being able to make its
payments. After all, some of the company's obligations will be to you if you
choose to invest in it. We
will start with Liquidity Ratios, an important topic for all investors. |
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The
following liquidity ratios are all designed to measure a company's ability to
cover its short-term obligations. Companies will generally pay their interest
payments and other short-term debts with current assets. Therefore, it is
essential that a firm have an adequate surplus of current assets in order to
meet their current liabilities. If a company has only illiquid assets, it may
not be able to make payments on their debts. To measure a firm's ability to
meet such short-term obligations, various ratios have been developed. You
will study the following balance sheet ratios:
These
tools will be invaluable in making wise investment decisions. |
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CURRENT
RATIO |
The
Current Ratio measures a
firm's ability to pay their current obligations. The greater extent to which
current assets exceed current liabilities, the easier a company can meet its
short-term obligations. Current
Assets Current Ratio = --------------------------- Current
Liabilities After
calculating the Current Ratio for a company, you should compare it with other
companies in the same industry. A ratio lower than that of the industry
average suggests that the company may have liquidity problems. However, a
significantly higher ratio may suggest that the company is not efficiently
using its funds. A satisfactory Current Ratio for a company will be within
close range of the industry average. |
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ACID TEST OR QUICK RATIO |
The
Acid Test Ratio or Quick Ratio is very similar to the Current Ratio except
for the fact that it excludes inventory. For this reason, it's also a more
conservative ratio. Current Assets - Inventory Acid test = --------------------------- Current Liabilities Inventory
is excluded in this ratio because, in many industries, inventory cannot be
quickly converted to cash. If this is the case, inventory should not be
included as an asset that can be used to pay off short-term obligations. Like
the Current Ratio, to have an Acid Test Ratio within close range to the
industry average is desirable. |
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WORKING
CAPITAL |
Working
Capital is simply the amount that current assets exceed current liabilities.
Here it is in the form of the equation: Working Capital = Current Assets - Current
Liabilities This
formula is very similar to the current ratio. The only difference is that it
gives you a dollar amount rather than a ratio. It too is calculated to
determine a firm's ability to pay its short-term obligations. Working Capital
can be viewed as somewhat of a security blanket. The greater the amount of
Working Capital, the more security an investor can have that they will be
able to meet their financial obligations. You
have just learned about liquidity and the ratios used to measure this. Many
times a company does not have enough liquidity. This is often the cause of
being over leveraged. |
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Leverage
is a ratio that measures a company's capital structure. In other words, it
measures 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. Long-term Debt Leverage = ---------------------- Total Equity A
firm that finances its assets with a high percentage of debt is risking
bankruptcy should it be unable to make its debt payments. This may happen if
the economy of the business does not perform as well as expected. A firm with
a lower percentage of debt has a bigger safety cushion should times turn bad.
A
related side effect of being highly leveraged is the unwillingness of lenders
to provide more debt financing. In this case, a firm that finds itself in a
jam may have to issue stock on unfavorable terms. All in all, being highly
leveraged is generally viewed as being disadvantageous due to the increased
risk of bankruptcy, higher borrowing costs, and decreased financial
flexibility. On
the other hand, using debt financing has advantages. Stockholder's potential
return on their investment is greater when a firm borrows more. Borrowing
also has some tax advantages. 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 the lower risk inherent in this type of capital
structure. A stockholder would probably opt for a higher percentage of debt
than the bondholder in a firm's capital structure. Yet, a company that is
highly leveraged is also very risky for a stockholder. When a firm becomes over leveraged,
bankruptcy can result. |
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Bankruptcy is
a legal mechanism that allows creditors to assume control of a firm when it
can no longer meet its financial obligations. Bankruptcy is a result feared
by both stock and bond investors. Generally, the firm's assets are liquidated
(sold) in order to pay off creditors to the extent that is 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.
The stockholders' liability to creditors is limited to the amount invested.
Therefore, if a firm's liabilities exceed the liquidation value of their
assets, creditors also stand to lose money on their investments. When
bankruptcy occurs, a federal court official steps in and handles the payments
of assets to creditors. The
remaining funds are always distributed to creditors in a certain pecking
order: |
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1. Unpaid taxes to the IRS
and bankruptcy court fees |
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Obviously,
to hold secured bonds rather than unsecured bonds is more advantageous in the
event of a bankruptcy. This is where you must examine your risk/reward
requirements. As you move down this hierarchy, your risk of losing your
investment increases. However, you are "rewarded" for taking more
risk with potentially higher investment returns. How
do you predict bankruptcy? Well, no one can do it perfectly. We
will recap a few of the most important points about learning to analyze a
company's balance sheet. |
|
TYING
IT ALL TOGETHER |
Analyzing
a balance sheet is fundamental knowledge for anyone who wishes to carefully
select solid and profitable investments. The balance sheet is the basic
report of a firm's possessions, debts and capital. The composition of these
three items will vary dramatically from firm to firm. As an investor, you
need to know how to examine and compare balance sheets of different companies
in order to select the investment that meets your needs. After
reading this tutorial, you should have an understanding of liquidity,
leverage and bankruptcy and know how to apply basic ratios to measure each.
These ratios should be compared to other firms in the same industry in order
for them to have relevance. Be careful, however, that the firms are not
fundamentally different even if they are in the same industry. |
UNDERSTANDING A COMPANY’S INCOME
STATEMENT
A
company's income statement is a
record of its earnings or losses for a given period. It shows all of the money
a company earned (revenues) and all of the money a company spent (expenses)
during this period. It also accounts for the effects of some basic accounting
principles such as depreciation.
The
income statement is important for investors because it's the basic measuring
stick of profitability. A company with little or no income has little or no
money to pass on to its investors in the form of dividends. If a company
continues to record losses for a sustained period, it could go bankrupt. In
such a case, both bond and stock investors could lose some or all of their
investment. On the other hand, a company that realizes large profits will have
more money to pass on to its investors.
In
this tutorial, we will provide the following:
An Example Of An
Income Statement
Gross Profit On
Sales
Operating Income
Earnings Before
Interest And Taxes
Net Earnings (Or
Loss)
Retained Earnings
Income Statement
Mnemonics
The Importance Of
The Income Statement To Investors
|
AN EXAMPLE OF AN INCOME
STATEMENT |
The
income statement shows revenues and expenditures for a specific period,
usually the fiscal year. Income statements differ by how much information
they provide and the style in which they provide the information. Here is an
example of a hypothetical income statement, with revenues and expenditures: |
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ABC Industries Income
Statements for the Years Ending 2003 and 2004 |
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|
2003 |
2004 |
|
Sales |
Rs. 900,000 |
Rs. 990,000 |
|
Less Cost of Goods Sold |
(250,000) |
(262,500) |
|
Gross Profit on Sales |
650,000 |
727,500 |
|
Less
General Operating Expenses |
(120,000) |
(127,500) |
|
Less
Depreciation Expense |
(30,000) |
(30,000) |
|
Operating Income |
500,000 |
570,000 |
|
Other
Income |
50,000 |
30,000 |
|
Earnings Before Interest and Tax |
550,000 |
600,000 |
|
Less Interest Expense |
(30,000) |
(30,000) |
|
Less Taxes |
(50,000) |
(54,500) |
|
Net Earnings (Available Earnings for Dividends) |
470,000 |
515,500 |
|
Less Common and/or Preferred Dividends Paid |
(70,000) |
(80,000) |
|
Retained Earnings |
400,000 |
435,500 |
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|
Now,
as perplexing as those numbers might seem at first, you will become
comfortable with them very quickly once we explain what all this financial
jargon really means. Let us start by looking at the first term that was
calculated - Gross Profit on Sales. |
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Gross Profit on Sales (also called gross margin) is the difference from
all the revenue the company earns from the sales of its products minus the
cost of what it took to produce them. Let us move on to clarify how to
calculate this important number. Sales - Cost of Goods Sold = Gross Profit on Sales Simple,
yes, but let's be sure we know what the terms sales and costs of goods sold
means to the accountants. Net Sales are
the total revenue generated from the sale of all the company's products or
services minus an allowance for returns, rebates, etc. Sometimes on an income
statement, you might see the terms "Gross Sales" and
"Returns", "Rebates" or "Allowances". Gross
sales are the total revenue generated from the company's products or services
before returns or rebates are deducted. Net Sales on the other hand have all
these expenses deducted. Cost of
Goods Sold is what the company spent to make the things it sold. Cost
of Goods Sold includes the money the company spent to buy the raw materials
needed to produce its products, the money it spent on manufacturing its
products and labor costs. When
you subtract all the money the company spent in the production of its goods
and services (Cost of Goods Sold)
from the money made from selling them (Net
Sales), you have calculated their Gross Profit on Sales. Gross
profit on sales is important because it reveals the profitability of a
company's core business. A company with a high gross profit has more money
left over to pump into research and development of new products, a big marketing
campaign, or better yet - to pass on to its investors. Investors should also
monitor changes in gross profit percentages. These changes often indicate the
causes of decreases or increases in a company's profitability. For instance,
a decrease in gross profit could be caused by an industry price war that has
forced the company to sell its products at a lower price. Poor management of
costs could also lead to a decreased gross profit. |
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|
Operating Income is a company's earnings from its core operations after it has
deducted its cost of goods sold and its general operating expenses. Operating
income does not include interest expenses or other financing costs. Nor does
it include income generated outside the normal activities of the company,
such as income on investments or foreign currency gains. An
easy way to calculate Operating Income is as follows: Operating Income = Gross profit - General
Operating Expenses - Depreciation Expense
General Operating Expenses are normal expenses incurred in the day-to-day
operation of running a business. Typical items in this category include sales
or marketing expenses, salaries, rent, and research and development costs. Depreciation
is the gradual loss in value of equipment and other tangible assets over the
course of its useful life. Accountants use depreciation to allocate the
initial purchase price of a long-term asset to all of the periods for which
the asset will be used. Operating Income is particularly important because it is a measure of profitability
based on a company's operations. In other words, it assesses whether or not
the foundation of a company is profitable. It ignores income or losses
outside of a company's normal domain. It also excludes extraordinary events,
such as lawsuits or natural disasters, which in a typical year would not
affect the company's bottom line. Read
below to learn about another important figure - Earnings before interest and
taxes (EBIT) |
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EARNINGS BEFORE INTEREST
AND TAXES |
Earnings Before Interest and Taxes (EBIT) is the sum of operating and non-operating income.
This is typically referred to as "other income" and
"extraordinary income (or loss)". As its name indicates, it is a
firm's income excluding interest expenses and income tax expenses. EBIT is
calculated as follows: EBIT = Operating Income +(-) Other Income (loss)
+(-) Extraordinary Income (loss) Since
we already know what operating income is, let's take a closer look at what
other income and extraordinary income (loss) mean. Other Income
generally refers to income generated outside the normal scope of a company's
typical operations. It includes ancillary activities such as renting an idle
facility or foreign currency gains. This income may happen on an annual
basis, but it is considered unrelated to the company's typical operations. Extraordinary Income (Loss) occurs when money is gained (lost) resulting from an
event that is deemed both unusual and infrequent in nature. Examples of such
extraordinary happenings could include damages from a natural disaster or the
early repayment of debt. Many
companies may not have either Other Income or Extraordinary Income in a given
year. If this is the case, then earnings before income and taxes is the same
as Operating Income. Regardless of how it is calculated, EBIT is especially
relevant to bondholders and other debtors who use this figure to calculate a
firm's ability to "cover" or pay its interest payments with its
income for the year. |
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|
Net Earnings or Net Income is the proverbial bottom line. It measures the
amount of profit a company makes after all of its income and all of its
expenses. It also represents the total dollar figure that may be distributed
to its shareholders. Net Earnings are also the typical benchmark of success.
Just a reminder, however, many companies report net losses rather than net
earnings. How
do we calculate net earnings? Net Earnings = Earnings before Interest and Taxes
- Interest Expense - Income Taxes Interest
Expense refers to the amount of interest a company has paid to its debtors in
the current year. Meanwhile, Income Taxes are federal and state taxes based
upon the amount of income a company generates. Often a company will defer its
taxes and pay them in later years. Net
earnings are particularly important to equity investors because it is the
money that is left over after all other expenses and obligations have been
paid. It is the key determinant of what funds are available to be distributed
to shareholders or invested back in the company to promote growth. |
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Retained Earnings are the amount of money that a company keeps for future use or
investment. Another way to look at it is as the earnings left over after
dividends are paid out. Generally, a company has a set policy regarding the
amount of dividends it will pay out every year. In this case, 70% of net
earnings become retained earnings. Calculation
of Retained Earnings: Retained Earnings = Net Earnings - Dividends To
better understand Retained Earnings, we need to explain the nature of
dividends. Dividends are cash payments made to the owners or stockholders of
the company. A profitable year allows them to make such payments, although
there generally are no obligations to make dividend payments. When a company
has both common and preferred stockholders, the company has two different
types of dividends to pay. Every
company has common stockholders. Dividend payments to common stockholders are
optional and up to each company to decide if or how it will make such
payments. A firm may decide to plow all of its earnings into new investments
to promote future growth. Preferred stockholders are in line before common
stockholders if a dividend is declared. However, not all companies have
preferred stockholders. As
an investor, to know what a company does with its net earnings is important.
An investor needs to know the company's dividend and retained earnings
policies to decide whether the company's objectives are inline with the
investors. If the company pays dividends it is income oriented. If it retains
earnings for future expansion, it is growth oriented. Knowing
the sources of income and expenses is necessary when reading an income
statement. Two helpful mnemonic devices have been created out of the major
components of the income statement. |
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|
Although
these mnemonics may not account for every line on an income statement, these
two will help you remember the major parts, and the order in which they
appear. The word "SONAR"
identifies the major sales and earnings. The word "EDIT" summarizes major expenditures. As
you look vertically down the first row of letters, you should discover the
spelling of "SONAR".
The vertical set of letters in the second column spells out "EDIT". S = Sales (gross) E = Less
expenses (general operating expenses and cost of goods sold) D = Less
depreciation O = Operating income (before
interest and taxes) I = Less
interest T = Less
taxes N = Net earnings A = Available earnings for common
stock R = Retained earnings Let's
conclude with a review of the importance of the income statement for
investors. |
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THE
IMPORTANCE OF THE INCOME STATEMENT TO INVESTORS |
The
Income Statement provides the investor with much insight to the company's
revenues and expenses. You can identify where the company spends much of its
income and compare that to similar companies. You can also compare a
company's performance with previous years. Most importantly, the income
statement tells an investor if the business is profitable. If the company
continually makes substantial profits, it indicates to bondholders that it is
a stable company. The savvy investor will compare income statements of
similar companies. |
This
concludes our brief lesson on understanding the income sheet. To prepare
yourself for the next tutorial, you will want to look over the sample income
sheet provided at the beginning of this tutorial and try to make some simple
analysis. Ask yourself a question like did the sales increase from one year to
the next? What was the Gross Profit? And most importantly did the shareholders
receive more money in dividends from one year to the next?
INCOME STATEMENT ANALYSIS
The
income statement is a basic record for reporting a company's earnings. Since
earnings are a fundamental component in a firm's worth, it is essential for
investors to know how to analyze different elements of this important document.
This
tutorial is designed to teach you some basic methods for analyzing the income
statement. Analyzing income statements is an important tool to help investors
appraise their investment options. By analyzing an income statement properly,
investors can begin to evaluate the effectiveness of the management of
operations in the companies in which they are interested in investing. Proper
income sheet analysis can help identify good investment opportunities. It can
also reduce the risk involved with choosing a poor investment choice.
In
this tutorial, we introduce you to the following ratios, tools and concepts to
help you analyze income statements:
Interest Coverage
Profitability
Ratios
Where Did All
Those Expenses Come From?
Depreciation
Expense
Basic Points About
Calculating Depreciation
Straight-Line
Depreciation
Selecting A
Depreciation Method
|
INTEREST COVERAGE (TIMES INTEREST EARNED) |
Interest Coverage is the
measurement of how many times interest payments could be made with a firm's
earnings before interest expenses and taxes are paid. From a bondholder's
perspective, interest coverage is a test to see whether a firm could have
problems making their interest payments. From an equity holder's perspective,
this ratio helps to give some indication of the short-term financial health
of the company. The following formula is used to determine the
coverage of interest: EBIT Interest Coverage Ratio = ---------------- Interest Expense A higher ratio is typically better for bondholders
and equity investors. For bondholders a high ratio indicates a low
probability that the firm will go bankrupt in the near term. A company with a
high interest coverage ratio can meet their interest obligations several
times over. Stock investors typically like companies with high interest
coverage ratios too. A high ratio indicates a company that is probably
relatively solvent. Thus, all other things equal, an investor should be very
careful with firms that have a low Interest Coverage Ratio with respect to
other companies in their industry. Since the fundamental purpose of the income statement
is to report profits or losses, understanding the various profitability
ratios that follow is extremely helpful to your analysis of a firm. |
|
PROFITABILITY RATIOS |
Profitability is often
measured in percentage terms in order to facilitate making comparisons of a
company's financial performance against past year's performance and against
the performance of other companies. When profitability is expressed as a percentage (or
ratio), the new figures are called profit margins. The most common profit
margins are all expressed as percentages of Net Sales. Let's look at a few of the most commonly used profit
margins that you can easily learn to use to help you measure and compare
firms:
Net Sales = Rs. 1,000 Cost of Goods
Sold = 400 Gross Profit = 600
Gross
Profit Gross Margin = ---------------- Net Sales In this example
the Gross Margin = 600/1000 = .60 or 60% Since this ratio
only takes into account sales and variable costs (costs of goods sold), this
ratio is a good indicator of a firm's efficiency in producing and
distributing its products. A firm with a ratio superior to the industry
average demonstrates superior efficiency in its production processes. The
higher the ratio, the higher the efficiency of the production process.
Investors tend to favor companies that are more efficient.
Operating
Income Operating Margin = ---------------- Net Sales This ratio
measures the quality of a firm's operations. A firm with a high operating
margin in relation to the industry average has operations that are more
efficient. Typically, to achieve this result, the company must have lower
fixed costs, a better gross margin, or a combination of the two. At any rate,
companies that are more efficient than their competitors in their core operations
have a distinct advantage. Efficiency is good. Advantages are even better.
Most investors will tend to prefer a more efficient company. Let's move on to
the last profitability measure we will cover in this tutorial.
Net Profit Net Margin = --------------- Net Sales As with the other
ratios you will want to compare Net margin with other companies in the
industry. You can also track year-to-year changes in net margin to see if a
company's competitive position is improving, or getting worse. The higher the
net margin relative to the industry (or relative to past years), the better.
Often a high net margin indicates that the company you are looking at is an
efficient producer in a dominant position within its industry. However, as
with all the previous profit margin measurements, you need to always check
past years of performance. You want to make sure that good results are not a
"fluke." Strong profit margins that are sustainable indicate that a
company has been able to consistently outperform their competitors. The savvy investor uses profitability margins to help
analyze income statements of prospective investments. Companies with high
interest coverage ratios, gross margins, operating margins and net margins
will always be very attractive to investors. |
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WHERE DID ALL THOSE EXPENSES COME FROM? |
You have just finished learning about interest
coverage and profitability ratios. Both of these measures are simple and easy
to understand. Interest coverage measures a company's ability to make its
loan payments. Profitability ratios measure the bottom line of the income
statement - earnings. However, to calculate either ratio, you must be able
to classify a company's expenses. The interest coverage ratio concerns itself
with a specific type of expense (interest expense). Meanwhile, profitability
ratios such as net profit margin consider the net effect of all the expenses
a company incurs. Most of the expenses, a company incurs (raw
materials, labor, rent, etc.), are straightforward items. In general,
companies want to minimize these sorts of expenditures to ensure improved
performance and profitability. For example, the less a company has to pay for
the raw materials of the products it produces, the more competitive that
company can become. Yet, there is one type of expense companies cannot
eliminate. In fact, incurring this expense actually helps save the company
money. What is this mysterious expense? |
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|
Depreciation is the process by which a company
gradually records the loss in value of a fixed asset. The purpose of
recording depreciation as an expense over a period is to spread the initial
purchase price of the fixed asset over its useful life. Each time a company prepares its financial
statements, it records a depreciation expense to allocate the loss in value
of the machines, equipment or cars it has purchased. However, unlike other
expenses, depreciation expense is a "non-cash" charge. This simply
means that no money is actually paid at the time in which the expense is
incurred. Like all other expenses, depreciation expense reduces
the taxable income of the company. Yet, a business reporting a depreciation
expense incurs no additional cash expenditure. Simply put, depreciation
allows businesses to reduce their taxable income without making the
additional cash expenditure typical of most other expenses. While depreciation is an attractive way to reduce
taxable income, specific regulations govern how it is to be calculated and
allocated. Let's take a moment to review a few important points about how
companies calculate depreciation. |
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BASIC POINTS ABOUT CALCULATING DEPRECIATION |
When analyzing income statements, it is very
important to understand how different accounting methods for calculating
depreciation affect the income statement. Sometimes the accounting methods
selected can materially alter the net result of this important statement. Most businesses have the right to choose amongst a
number of different depreciation schedules. Typically, businesses elect a
depreciation schedule to suit their specific needs or preferences. In order
to make comparisons of different companies, you will need to know the role
that accounting plays in the final composition of their respective income
statements. A company can choose from several methods (or
depreciation schedules) to calculate its depreciation expense. Read below to
look at two of the most common methods. |
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|
Straight-line Depreciation is the simplest and
most commonly used accounting method for depreciation. Basically, the
straight-line depreciation method calculates the amount of annual
depreciation expense that is to be recorded by dividing the value of the
asset (as determined by its purchased price) by its useful life. Often some
adjustment is made for the anticipated "residual value" that the
asset may have at the end of its "useful life." The Income Tax authority provides taxpayers with a
depreciation schedule that defines what the useful life of different types of
assets (cars, computers, etc.) is to be. Thus, an item that has a relatively
short-lived useful life (such as a computer) may be able to be depreciated
more quickly than an asset (such as a building) that has a long and useful
life expectancy ahead of it. Using a straight-line depreciation schedule,
businesses deduct the same amount of depreciation each year until the assets
has been fully depreciated. However, straight-line depreciation is not the only
method available. Let's look at another popular option. |
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|
Accelerated Depreciation
Methods are also a very common way for companies to allocate
their depreciation expenses. These methods are those methods that are
utilized to write off depreciation costs more rapidly than the straight-line
method. Various accelerated methods exist. Two popular
methods of accelerated depreciation are Sum-of-the-Years'-Digits and Double
Declining Balance. These methods are more complex in nature and we will not
delve into their calculations at present. However, the important thing to know is that each of
these methods record depreciation expense more heavily in the current years
in comparison to the straight-line method. By recording more expense in the
early stages of an assets useful life, accelerated depreciation methods
reduce the taxable income for those years and thus reduce income taxes for
those years. However, in later years, accelerated depreciation methods will
record less depreciation, leaving more income. The company will therefore
have to pay greater taxes. |
|
SELECTING A DEPRECIATION METHOD |
For the company, the choice of depreciation method
will depend on a company's current financial situation and/or its own
preferences. Companies that wish to defer current taxable income may elect
accelerated depreciation methods to accomplish this goal. However, companies
that need to show large earnings in the current year may elect to forgo
accelerated depreciation methods and opt for a straight-line method. Both
methods have their advantages and disadvantages. Typically, a company is free
to choose the method that best suits its preferences. However, as an investor, you will likely not have the
power to tell the company what method to use. Instead you will need to know
how each of these different methods can alter an income statement. If you can
do this, you will be able to evaluate how a company's depreciation schedule
impacts the value of the investment opportunity. When making comparisons of different companies, you
should always check to see if they use the same accounting methods. If not,
you will want to make an adjustment in order to effectively compare these
companies. At first, comparing depreciation methods and
accounting rules may seem daunting. However, with a little practice you will
be armed and ready to really understand the companies you are interested in
investing in. |
|
CONCLUDING REMARKS |
Now that you have completed this tutorial, you should
be familiar with some basic methods to help you evaluate different investment
options. Using the analysis techniques that we have
introduced, you have a good basis of knowledge from which to make informed
investment decisions. Remember that the main purpose of the income statement
is to report profitability. Because profitability is crucial in any
investment decision, knowing some basic techniques of how to analyze the income
statement should be a very important part in your development as an informed
investor. It is also important that you learn to analyze other
financial statements (such as the balance sheet and the statement of cash
flows). For more information on these and other related subjects please read
the other tutorial topics in the Security Analysis section. |
FUNDAMENTAL VS. TECHNICAL ANALYSIS
Investors
are always looking for a better way to pick securities. Two types of data
analysis have emerged to assist investors in making better investment
decisions. In this tutorial, we will introduce you to fundamental and technical
analysis.
What Is A
Fundamental Analysis?
What Is A
Technical Analysis?
Which Type of
Analysis Is Better for You?
|
WHAT IS A FUNDAMENTAL ANALYSIS? |
Fundamental Analysis is a method
used to evaluate the worth of a security by studying the financial data of
the issuer. It scrutinizes the issuer's income and expenses, assets and
liabilities, management, and position in its industry. In other words, it
focuses on the "basics" of the business. If you want to use fundamentals to help you make an
investment decision, you would rely heavily on an offering prospectus, annual
and quarterly reports as well as any current news items relating to the
issuer whose securities you are considering. A technical analysis takes a different approach. |
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|
Technical Analysis is a method
used to evaluate the worth of a security by studying market statistics.
Unlike fundamental analysis, technical analysis disregards an issuer's
financial statements. Instead, it relies upon market trends to ascertain
investor sentiment to predict how a security will perform. If you want to use technical analysis to help you
make an investment decision, you will refer to financial charts, tables and
ratios found in the financial press. You will look for market trends and
averages to help you decide whether the "time is right" to make an
investment. As you can see, the two types of analysis are very
different. Read below to see which type of analysis is better for you. |
|
WHICH TYPE OF ANALYSIS IS BETTER FOR YOU? |
Fundamentalists and technicians have been at odds
with one another since the advent of investing. There is no clear answer as
to which is right. Sometimes it appears that the technicians make better
picks. Other times it seems the fundamentalists are making the right call.
One thing is certain, when one group of analysts is wrong the other will
surely emerge saying, "We told you so." So, which is right for you?
There are many potential answers to that question. Three variants of popular
answers are:
Today, many investors find both fundamental and
technical analysis helpful in painting a more complete and colorful picture
on the investment canvas. Whether you use an asset allocation, buy and hold,
or market timing strategy, you will find useful information from both the
fundamentalists and technicians. The technicians can tell you about the broad
market and its trends. The fundamentalists tell you whether an issue has the
"basics" necessary to meet your investment objectives. |
|
CONCLUDING REMARKS |
Fundamental and Technical analysis differ radically
in their approaches. Which method has yielded better returns over a suitable
period of study has no clear answer. Nonetheless, by familiarizing yourself
with the tactics and techniques of each you will most likely be better suited
to make your own investment decisions. Try using the best ideas from each
camp and you should be pleased with the results. This concludes our tutorial on Fundamental and
Technical analysis. |