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Introduction to
Fundamental Analysis
- The Accounting Process
- Postulates and Principles
of Accounting
* Postulates of Accounting
* Principles of Accounting
- The Financial Statements
* The Balance Sheet
* The Income Statement
* The Cash Flow Statement
* Shareholders' Equity
Statement
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The Income Statement
The income statement, also called the profit and loss
statement (“P&L”), reports the results of operations for a period of time.
It uses the basic formula of revenues minus expenses equal net income.
Revenues are resources received from the sale of products or services;
expenses are resources paid for goods or services. Net income, commonly
known as “the bottom line,” represents after tax profits earned for the
period. For publicly traded companies, the accrual basis of accounting is
used to properly match revenues with associated expenses. Income statement
accounts are temporary. At the end of the annual reporting period, they are
transferred (closed out) to the retained earnings section of the balance
sheet, thus maintaining the duality of double entry accounting.
The income statement is the key barometer used in
picking and valuing stocks. The critical issue to remember is that the
income statement measures accounting income, not cash income. It’s the cash
income of a company that ultimately builds wealth and pays dividends, not
accounting income. Nonetheless, the investment community continues to focus
on the income statement.
There are a few tools from the income statement that
investors use to evaluate companies:
·
Earnings Per Share (“EPS”) and the Price Earnings
Ratio (“P/E Ratio”):
EPS is the portion
of net income attributed to one common share of stock.
The PE Ratio is the
EPS multiple that investors are paying for the stock. These are readily
available figures that make it easy to compare one company to the next in
similar industries. A good investment is a company that can grow EPS, as
well as increase its P/E multiple.
·
Profit Margins – These profitability ratios
measure how much income is generated from revenues. Margins are a good
indication of how profitable a company’s products are. Investors typically
pay a higher premium for higher margin businesses and less for low margin,
commodity type businesses. Investors normally pay for profits, not
revenues.
·
Return on Equity (“ROE”) – The single best tool
used to determine how a company is managed. ROE is the percentage of profits
earned on a company’s capital. To a certain degree, the higher the returns
the more efficient capital is being deployed. Earnings (net income) by
itself is just a number, but by comparing it with owners’ equity and
calculating a return on equity, investors are able to compare the returns
from unrelated investments. ROE allows investors to compare the returns from
cash, stocks, real estate, and other investment vehicles. All things being
equal, the higher the return the better.
·
R&D to Sales Ratio – This ratio measures a company’s
investment in future products.
·
Activity Ratios – They measure management’s
efficiency. Receivable Turnover and Inventory Turnover Ratios
gauge how fast a company is converting its short-term resources into cash;
to monetize its profits.
Properly using the information generated on the
income statement is one of the steps in using fundamental analysis to make
profitable investment decisions.
Medtronic’s income statement is an example of a
single-step condensed financial statement. Companies also use a multi-step
format that groups accounts by significant categories, making the income
statement more “analysis friendly.”
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Medtronic, Inc.
Consol. Statement of Earnings
($ in millions, except per
share data) |
Fiscal Yr.
2005 |
Fiscal Yr.
2004 |
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Net sales |
$ 10,054.6 |
$ 9,087.2 |
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Costs and
expenses: |
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Cost of
product sold |
2,446.4 |
2,252.9 |
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Research
and development exp. |
951.3 |
851.5 |
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Selling,
general and adm. exp. |
3,213.6 |
2,801.4 |
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Purchased
in-process R&D |
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41.1 |
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Special
charges |
654.4 |
(4.8) |
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Other
expenses, net |
290.5 |
351.0 |
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Interest
(income) / expense |
(45.1) |
(2.8) |
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Total
costs and expenses |
7,511.1 |
6,290.3 |
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Earnings before
income taxes |
2,543.5 |
2,796.9 |
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Provision for
income tax |
739.6 |
837.6 |
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Net earnings |
$ 1,803.9
======== |
$ 1,959.3
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Earnings per
share: |
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Basic |
1.49 |
1.61 |
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Diluted |
$ 1.48
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$ 1.60
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Weighted average
shares outstanding: |
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Basic |
1,209.0 |
1,213.7 |
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Diluted |
1,220.8 |
1,225.9 |
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Medtronic, Inc.
Income Statement Statistics |
Fiscal Yr.
2005 |
Fiscal Yr.
2004 |
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Price
Earnings Ratio (“P/E Ratio”): |
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Year-end price –
per share |
$ 52.70 |
$ 50.46 |
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Diluted Earnings
– per share (“EPS”) |
1.48 |
1.60 |
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P/E Ratio |
35.61 x |
31.54 x |
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Net Profit
Margins: |
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Net sales |
10,054.6 |
9,087.2 |
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Net earnings |
1,803.9 |
1,959.3 |
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Net profit
margin percentage |
17.94 % |
21.56 % |
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R&D to
Sales Ratio: |
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Net sales |
10,054.6 |
9,087.2 |
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Research and
development expense |
951.3 |
851.5 |
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R&D as a
percentage to sales |
9.46 % |
9.37 % |
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Return on
Equity (“ROE”): |
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Net earnings |
1,803.9 |
1,959.3 |
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Average ending
equity |
9,763.3 |
8,491.7 |
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ROE |
18.48 % |
23.07 % |
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Receivable
Turnover: |
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Net sales |
10,054.6 |
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Average A/R |
2,143.5 |
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A/R turnover |
4.7 x |
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Days sales
uncollected |
77.7 days |
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Inventory
Turnover: |
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Cost of goods
sold |
2,446.4 |
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Average
inventory |
929.6 |
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Inventory
turnover |
2.6 x |
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Average days
inventory on hand |
140.4 days |
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Next review The Cash Flow
Statement |
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