How to Use Fundamental Analysis (2 min read)

Written By Millionaire’s Digest Team Member: Eric Bruin

Founder & Owner of: The Stock Trader Blog

Millionaire’s Digest Team, Contributor, Books, Business, Education, Entrepreneur, Politics and Successful Living Writer

When it comes to investing, fundamental analysis is one of the most helpful tools in the decision-making process. Looking at a company’s financial statements helps you get a better idea of what the company is doing right, what the company may be doing wrong, and where opportunities for improvement may come from.

There are four different types of financial statements. There is the income statement, the balance sheet, the statement of cash flows, and the statement of changes in equity. The statement of changes in equity is not incredibly important because its effect is incorporated in the other statements. Here is a breakdown of three of the important statements and what to look for in each one:

The Income Statement

Perhaps the most intuitive financial statement, the income statement shows the results of business operations over a given time period (typically on an annual or quarterly basis). There is revenue, followed by the cost of sales, and then administrative and other entity-level costs. Entity-level costs include everything from tax to interest expense. The resulting number is the net income for the business over the given time period. Publicly traded companies are required to show earnings per share and diluted earnings per share on the income statement. Earnings per share is calculated as net income/average number of shares outstanding. Diluted earnings per share adjust the earnings per share number to account for equity issued during the time period. Earnings per share (EPS) can be used to show how expensive or cheap a stock is. If a stock is priced at $10, and the EPS is $1, then the stock trades at 10x earnings. Compared to historic levels of the overall market, that would be a pretty cheap stock. On the other hand, if a stock trades at $100, and the EPS is $1, then the stock trades at 100x earnings which is very expensive on a historical basis.

The Balance Sheet

The balance sheet can be more difficult to grasp than the income statement. This financial statement shows a snapshot of a company’s financial position at a certain period in time. For large companies, the balance sheet is consolidated to make it easier for investors to see top-level balances of important assets and liabilities. This can make it more difficult to analyze though because the asset, liability and equity amounts are the results of combining many smaller accounts.

Within the balance sheet, there are current assets (such as cash, inventory, and accounts receivable), long-term assets (like property, plant, and equipment), current liabilities (short-term debt for example), long-term liabilities (long-term debt typically), and equity (common stock, additional paid-in capital, etc.). Learning about accounting methods is important when analyzing balance sheets because certain items, such as property, are recorded at historical cost and do not reflect current values. Comparing things like cash and cash equivalents to short-term debt can give you a better understanding of how well a company can cover its debt payments.

The Statement of Cash Flows

The statement of cash flows is one of the most important financial statements for investors. Seeing how a company funds its business operations can tell a lot about the company. There are three components to the statement of cash flows. The first is cash flows provided (or used) by operations. This shows how much cash was generated by normal business activities. Then there is a section called cash flows provided (or used) by investing activities. This shows how much cash was used or spent on things like purchasing buildings, land, equipment, etc. The final section is called cash flows provided (or used) by financing activities. This section is vitally important because it shows investors if the company is using debt to fund its operations or if it is doing things like buying back stock.

A financially healthy company tends to have positive cash flows from business operations and negative cash flows from investing activities. This implies that the business is generating money, and it is using its cash to invest in growing itself. The financing section can vary, but most profitable businesses have negative cash flows from financing activities.

Article Credits: Eric Bruin

Millionaire’s Digest Team, Contributor

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