Fundamental Analysis - Meaning, Types, Tools & Techniques, Objectives and Limitations

Fundamental Analysis of Companies
Unit 1 SAPM Notes 
Concept of Investments

Fundamental Analysis Meaning

Fundamental analysis is method of finding out the future price of a stock which an investor wishes to buy. Fundamental analysis is used to determine the intrinsic value of the share of a company to find out whether it is overpriced or under priced by examining the underlying forces that affect the well being of the economy, Industry groups and companies.

Fundamental analysis is simply an examination of future earnings potential of a company, by looking into various factors that impact the performance of the company. The prime objective of a fundamental analysis is to value the stock and accordingly buy and sell the stocks on the basis of its valuation in the market. The fundamental analysis consists of economic, industry and company analysis. This approach is sometimes referred to as a top-down method of analysis.

Types of fundamental analysis to be done before making Investment

The actual value of a security, as opposed to its market price or book value is called intrinsic value. The intrinsic value includes other variables such as brand name, trademarks, and copyrights that are often difficult to calculate and sometimes not accurately reflected in the market price. One way to look at it is that the market capitalization is the price (i.e. what investors are willing to pay for the company and intrinsic value is the value (i.e. what the company is really worth). The fundamental analysis consists of economic, industry and company analysis. This approach is sometimes referred to as a top-down method of analysis.

a)       At the economy level, fundamental analysis focus on economic data (such as GDP, Foreign exchange and Inflation etc.) to assess the present and future growth of the economy.

b)      At the industry level, fundamental analysis examines the supply and demand forces for the products offered.

c)       At the company level, fundamental analysis examines the financial data (such as balance sheet, income statement and cash flow statement etc.), management, business concept and competition.

a)      ECONOMIC ANALYSIS: Economic analysis occupies the first place in the financial analysis top down approach. When the economy is having sustainable growth, then the industry group (Sectors) and companies will get benefit and grow faster. The analysis of macroeconomic environment is essential to understand the behavior of the stock prices. The commonly analysed macro economic factors are as follows:

a)      gross domestic product (GDP) growth rate

b)      exchange rates

c)       balance of payments (BOP)

d)      current account deficit

e)      government policy (fiscal and monetary policy)

f)        domestic legislation (laws and regulations)

g)       unemployment rates

h)      public attitude (consumer confidence)

i)        inflation

j)        interest rates

k)       productivity (output per worker)

l)        Capacity utilisation (output by the firm).

b)      INDUSTRY OR SECTOR ANALYSIS: The second step in the fundamental analysis of securities is Industry analysis. An industry or sector is a group of firms that have similar technological structure of production and produce similar products. These industries are classified according to their reactions to the different phases of the business cycle. They are classified into growth, cyclical, defensive and cyclical growth industry. A market assessment tool designed to provide a business with an idea of the complexity of a particular industry. Industry analysis involves reviewing the economic, political and market factors that influence the way the industry develops. Major factors can include the power wielded by suppliers and buyers, the condition of competitors and the likelihood of new market entrants. The industry analysis should take into account the following factors.

a)       Characteristics of the industry

b)      Demand and market for the product.

c)       Government policy

d)      Labour and other industrial problems exist or not.

e)      Capabilities of management.

f)        Future prospects of the industry

c)       COMPANY OR CORPORATE ANALYSIS: Company analysis is a study of variables that influence the future of a firm both qualitatively and quantitatively. It is a method of assessing the competitive position of a firm, its earning and profitability, the efficiency with which it operates its financial position and its future with respect to earning of its shareholders. This analysis can be done with the help of financial statements.

Tools and Techniques of Fundamental or Corporate Analysis

Financial statement means a statement or document which explains necessary financial information. Financial statements express the financial position of a business at the end of accounting period (Balance Sheet) and result of its operations performed during the year (Profit and Loss Account). In order to determine whether the financial or operational performance of company is satisfactory or not, the financial data are analyzed. Different methods are used for this purpose. The main techniques of financial analysis are:

The most commonly used techniques of financial analysis are as follows:

1. Comparative Statements: These are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to give an idea about the position of two or more periods. It usually applies to the two important financial statements, namely, balance sheet and statement of profit and loss prepared in a comparative form. The financial data will be comparative only when same accounting principles are used in preparing these statements. If this is not the case, the deviation in the use of accounting principles should be mentioned as a footnote. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal analysis’.

Merits of Comparative Financial Statements:

a)       Comparison of financial statements helps to identify the size and direction of changes in financial position of an enterprise.

b)      These statements help to ascertain the weakness and soundness about liquidity, profitability and solvency of an enterprise.

c)       These statements help the management in making forecasts for the future.

Demerits of Comparative Financial Statements:

a)       Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.

b)      Inter-period comparison will also be misleading if there is frequent changes in accounting policies.

2. Common Size Statements: These are the statements which indicate the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. The percentage thus calculated can be easily compared with the results of corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Thus, common size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical analysis’.

Merits of Common Size Statements:

a)       A common size statement facilitates both types of analysis, horizontal as well as vertical. It allows both comparisons across the years and also each individual item as shown in financial statements.

b)      Comparison of the performance and financial condition in respect of different units of the same industry can also be done.

c)       These statements help the management in making forecasts for the future.

Demerits of Common Size Statements:

a)       If there is no identical head of accounts, then inter-firm comparison will be difficult.

b)      Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.

c)       Inter-period comparison will also be misleading if there is frequent changes in accounting policies.

3. Trend Analysis: It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. The trend percentage is the percentage relationship, in which each item of different years bear to the same item in the base year. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good or poor management is detected.

Merits of Trend analysis:

a)       Trend percentages can be presented in the form of Index Numbers showing relative change in the financial statements during a certain period.

b)      Trend analysis will exhibit the direction to which the concern is proceeding.

c)       The trend ratio may be compared with the industry, in order to know the strong or weak points of a concern.

Demerits of Common Size Statements:

a)      These are calculated only for major items instead of calculating for all items in the financial statements.

b)      Trend values will also be misleading if there is frequent changes in accounting policies.

4. Ratio Analysis: It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm. As a technique of financial analysis, accounting ratios measure the comparative significance of the individual items of the income and position statements. It is possible to assess the profitability, solvency and efficiency of an enterprise through the technique of ratio analysis.

5. Funds flow statement: The financial statement of the business indicates assets, liabilities and capital on a particular date and also the profit or loss during a period. But it is possible that there is enough profit in the business and the financial position is also good and still there may be deficiency of cash or of working capital in business. Financial statements are not helpful in analysing such situation. Therefore, a statement of the sources and applications of funds is prepared which indicates the utilisation of working capital during an accounting period. This statement is called Funds Flow statement.

6. Cash Flow Analysis: A Cash Flow Statement is similar to the Funds Flow Statement, but while preparing funds flow statement all the current assets and current liabilities are taken into consideration. But in a cash flow statement only sources and applications of cash are taken into consideration, even liquid asset like Debtors and Bills Receivables are ignored. A Cash Flow Statement is a statement, which summarises the resources of cash available to finance the activities of a business enterprise and the uses for which such resources have been used during a particular period of time. Any transaction, which increases the amount of cash, is a source of cash and any transaction, which decreases the amount of cash, is an application of cash. Simply, Cash Flow is a statement which analyses the reasons for changes in balance of cash in hand and at bank between two accounting period. It shows the inflows and outflows of cash.

Objectives (Purposes) and significance of Financial Statement analysis:

Financial analysis serves the following purposes and that brings out the significance of such analysis:

a)       To judge the financial health of the company: The main objective of the financial analysis is to determine the financial health of the company. It is done by properly establishing the relationship between the items of balance sheet and profit and loss account.

b)      To judge the earnings performance of the company: Potential investors are primarily interested in earning efficiency of the company and its dividend paying capacity. The analysis and interpretation is done with a view to ascertain the company’s position in this regard.

c)       To judge the Managerial efficiency: The financial analysis helps to pinpoint the areas wherein the managers have shown better efficiency and the areas of inefficiency. Any favourable and unfavourable variations can be identified and reasons thereof can be ascertained to pinpoint weak areas.

d)      To judge the Short-term and Long-term solvency of the undertaking:  On the basis of financial analysis, Long-term as well as short-term solvency of the concern can be judged. Trade creditors or suppliers are mainly interested in assessing the liquidity position for which they look into the following:

Ø  Whether the current assets are sufficient to pay off the current liabilities.

Ø  The proportion of liquid assets to current assets.

e)      Indicating the trend of Achievements: Financial statements of the previous years can be compared and the trend regarding various expenses, purchases, sales, gross profits and net profit etc. can be ascertained. Value of assets and liabilities can be compared and the future prospects of the business can be envisaged.

f)        Inter-firm Comparison: Inter-firm comparison becomes easy with the help of financial analysis. It helps in assessing own performance as well as that of others.

g)       Understandable:  Financial analysis helps the users of the financial statement to understand the complicated matter in simplified manner.

h)      Assessing the growth potential of the business: The trend and other analysis of the business provide sufficient information indicating the growth potential of the business.

Limitations of financial analysis

Financial analysis suffers from various limitations which are given below:

a)       Historical Analysis: Financial analysis analysed what has happened till date but it does not reflect the future. Persons like shareholders, investors etc., are mainly interested in knowing the likely position in future.

b)      Ignores Price Level Changes: Price level change and purchasing power of money are inversely related. A change in the price level makes the financial analysis of different accounting years invalid because accounting records ignores change in value of money.

c)       Qualitative aspect Ignored: Since the financial statements are based on quantitative aspects only, the quality aspect such as quality of management, quality of labour force etc., are ignored while carrying out the analysis of financial statements.

d)      Suffers from the Limitations of financial statements: Since analysis of financial statements is based on the information given in the financial statements, it suffers from all such limitations from which the financial statements suffer.

e)      Not free from Bias: Financial statements are largely affected by the personal judgment of the accountant in selecting accounting policies. Therefore, financial are not free from bias.

f)        Variation is accounting practices: Different firms follow different accounting practices. Therefore, a meaningful comparison of their financial statements is not possible.