Introduction to Fundamental Analysis
Quantitative Analysis I.I
There are two main types of analysis: qualitative, which allows us to understand both the company and the industry, and quantitative, which leads to real valuation and provides an understanding of where the company is relatively to its competitors.
- THE BALANCE SHEET
This financial document provides information of the company’s assets, liabilities, and equity in a specific time. On the left you find the assets, and to the right both liabilities and equity, which are owned by investors (equity), bankers, and creditors (debt).
As you might have guessed, ‘the financing’ (equity and debt) allow the company to pay for its assets.
ASSETS = LIABILITIES + SHAREHOLDERS EQUITY
The ASSETS can be current or non current. Current assets can be converted into cash in 1 year or less. The most important ones to know are cash, inventory, and accounts receivables.
But how do each of these contribute to the overall performance of the company?
CASH
- Simply put, cash acts as a cushion when the company is going through difficult times, provides growth opportunities (R&D).
Decreasing cash for some time might be a bad sign. However, a stable high cash pile is also a red flag.
Does the management know what to do with the money? Are there any opportunities left in the industry for investment? If you doubt, you can always compare it to other ccompanies in the industry, especially their competitors. Bur remember, there should be a stable percentage of sales retained in cash! (varies from industry, but normally 2%)
INVENTORY
- These are almost finished products that are waiting to be sold.
Here, you should be looking at how fast the company is able to sell their products. If the inventory is too high, then there’s a lot of money there, but what why would they have it there for? Companies do not need inventory to be kept, they need to sell it. If the inventory grows faster than the sales, indicates deterioration and another red flag!
IF INVENTORY > SALES THEN :(
RECEIVABLES
- These are bills that have not been paid to the company yet. You still need to receive that money.
Now think about it, if a business’ report indicates that, over time, their ability to get paid on time is becoming weaker (they take longer) then this is something you need to look at. Why? Because if this happens, it means that the company is struggling to get cash flowing in.
The quicker the company gets the cash in, ‘the sooner it has cash to pay for merchandise, salaries, equipment, loans, dividends, and future growth opportunitties.’ (Hendriks et. al, 2020).
Non-current assets cannot be converted into cash quickly — in 1 year or less — and usually involve complex tax rules. These mostly affect the depreciation and profitability of the company. An example are fixed assets.
LIABILITIES = SHAREHOLDERS EQUITY — ASSETS
Liabilities are also divided into current and non-current.
Current liabilities need to be paid within a year while non current liabilities showcase what the business owes in a long period of time — like a bank or bondholder debt.
Let’s talk about debt… Don’t get scared because it’s not as bad as it sounds. Companies want to have part of their financing (remember this term?) in debt. Why? Because it reduces their taxes (tax-shift benefits).
Keep in mind that if the company’s debt is paid with more debt it does not mean that they cannot pay it. However, if the comparison with other industry players is big, then you need to dive deeper into that.
To know — more or less — how to guide yourself, you can look at the amount of stable income. If you’re looking into startups, they usually do not have big debts but corporates do. ‘Higher amounts of debt have the risk of earlier default’ (Hendriks et. al, 2020).
SHAREHOLDERS EQUITY = ASSETS — LIABILITIES
Equity is the amount of capital that shareholders own in a company. This is divided into paid-in capital — amount of money shareholders paid for shares in the company’s IPO (Initial Public Offering), and retained earnings — the money the company to retain or reinvest, which isn’t paid to the shareholders as dividends are. Here, look at how the company is investing these retained earnings and what return it is getting from it.
Now you can consider a pro of balance sheets. In the next article we will talk about the income statement before moving to the intrinsic value.
Bibliography:
B&R Investment Guide. Hendriks, P., Heeringa, M., Koenraadt, J., et. al (2020). Second Edition August 2020. B&R Beurs.
