Fundamental analysis of stocks: overview

Before reading this lesson, you should have read through:

There are a number of ways that a company can be evaluated when an investor or trader is deciding whether to buy or sell its shares.

Much of the information needed to make such a judgement can be found in a company's financial statement, which contains a vast amount of information pertaining to its performance.

This lesson will give you an introduction to what is contained within a financial statement. The subsequent lessons will show you how to use it to analyse a company and decide if its shares are worth buying or selling.

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A financial statement contains performance indicators

A financial statement allows you to examine a company's financial health, revealing how able it is to cover its debts and other obligations.

Much of the information needed to decide how financially healthy a company is, how effective its management is and how cheap or expensive its shares are can be found in its financial statement.

You can also look at its financial performance, which shows how efficient management is at turning assets into profit.

And you can look at how high or low its current share price is compared to its historical average and the company's "real" or fundamental value.

What is a financial statement?

A financial statement is a bit like a company's report card. It shows investors how it has performed over the past year or financial quarter, what levels of debt or assets it has on its books and how much profit or loss it has generated.

The main components of a financial statement are the:

They are usually filed in January, April, July and October.

The financial statement gives a detailed breakdown of a company's profit, sales, debt and other important figures like its price to earnings ratio and any dividends it plans to pay.

As well as giving a detailed breakdown of the company's profit, sales, debt and other important figures like its price to earnings ratio and any dividends it plans to pay, a financial statement will compare these with those of previous periods (usually a year earlier) and provide a prediction for the coming quarter and year.

Reports include comments from a company's management on why its results were as good or bad as they were and what the company plans to do to rectify or further improve its performance.

They also discuss market risks that the company is currently facing and any legal proceedings it may be involved in.

The balance sheet

The balance sheet provides a snapshot of a company at a specific point of time.

A balance sheet provides a snapshot of a company at a specific point in time, detailing everything that it owns (its assets), everything that it owes (its liabilities) and how much shareholders have invested in it (its shareholder equity).

Company assets

Current assets are assets that the company expects to sell and convert into cash within one year. Non-current assets are those that would take longer than a year to convert to cash.

Assets include physical property like equipment, inventory and production facilities. They also include intangible assets like trademarks and a company's brand. Also included as assets are any investments the company has made as well as any cash it is holding.

Assets are usually listed according to how quickly they could be converted into cash.

The term current assets is used to refer to assets that the company expects to sell and convert into cash within one year.

Non-current assets are those that would take longer than a year to convert to cash – these include fixed assets like office fittings that the company needs to run its business and does not intend to sell.

Company liabilities

Liabilities include any money that the company owes to banks, landlords, suppliers and employees.

Liabilities include any money that the company owes to banks, landlords, suppliers and employees. They also include tax owed to the government and future obligations to provide goods or services to customers.

Liabilities are usually listed according to their due dates. Current liabilities are those that a company expects to pay off within one year. Long-term liabilities are those that it expects to pay off more than one year later.

Shareholder equity is the money that could be returned to shareholders if the company sold all of its assets and paid off all its liabilities.

Profit and loss statement

The profit and loss statement shows what revenues a company has earned over a certain period of time and what expenses it has incurred. The difference between the two reflects the company's profit or loss.

The profit and loss statement (called the income statement in the US) details the revenues, costs and expenses that a company has generated.

Subtracting expenses from revenues shows how much profit or loss it has generated – the "bottom line".

Unlike the balance sheet, which zooms in on one point in time, the profit and loss statement provides figures for a period of time – usually a financial quarter or a year.

The statement includes any money that the company has received from selling its products or services to customers. Revenue is sometimes referred to as "net sales" or "operating revenue".

The statement includes within expenses its selling, general and administrative costs, any taxes it must pay and any depreciation of the value of its assets.

If the company's earnings exceed its expenses it has made a profit. If its expenses exceed its earnings it has made a loss.

The profit and loss statement also tells you how many of a company's shares are outstanding and presents useful measurements like the company's earnings per share and its diluted earnings per share.

The profit and loss statement gives shares investors useful information on how well the company is managing its costs and converting sales into income that it can invest in future growth.

Ratios

Ratios show the relationship between two different pieces of information in a company's financial statement.

There are different ways of interpreting a company's health and performance but one common way is by calculating a variety of ratios.

Ratios show the relationship between two different pieces of information in a company's financial statement – for example what proportion of debt and equity the company relies on for funding – and give you a rule-of-thumb way of measuring everything from how efficiently it uses its assets to how well it can cope with its current debt load.

Ratios are particularly useful in that they give you a concrete figure that you can use to compare different companies when you are deciding which to invest in.

Summary

This lesson has introduced to you the following points...

  • … much of the information needed to decide whether to buy or sell a company's shares can be found in its financial statement, which contains a vast amount of information pertaining to its performance.
  • … a financial statement allows you to examine a company's financial health, revealing how able it is to cover its debts and other obligations.
  • … you can also look at its financial performance, which shows how efficient management is at turning assets into profit.
  • … you can look at how high or low its current share price is compared to its historical average and the company's "real" or fundamental value.
  • … a financial statement comprises of a balance sheet and a profit and loss statement, and is usually filed in January, April, July and October.
  • … the balance sheet provides a snapshot of a company at a specific point in time, detailing everything that a company owns (its assets), everything it owes (its liabilities) and how much shareholders have invested in it (shareholder equity).
  • … the profit and loss statement details the revenues, costs and expenses that a company has generated over a period of time – usually a financial quarter or a year.
  • … ratios show the relationship between two different pieces of information in a company's financial statement and give you a rule-of-thumb way of measuring everything from how efficiently it uses its assets to how well it can cope with its current debt load.
  • … they are particularly useful in that they give you a concrete figure that you can use to compare different companies when you are deciding which to invest in.

What next?

To continue on with valuation methods, go to the following lesson:

Lesson
Look at indiivdual companies and break down their financial earnings reports. This helps determine if their share price is likely to rise or fall.
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