The Tools of the Fundamental Analysis Trade
You may appreciate the importance of fundamental analysis and may even be able to download fundamental data from websites or from a company’s annual report. But you need to have the tools to analyze the fundamentals to get any real value from them.
Staying focused on the bottom line
If there’s one thing investors may agree is of upmost importance, it’s the company’s profitability. When it comes down to it, when you invest in a stock you’re buying a piece of the company’s earnings. Knowing how to read and understand how much profit a company is making is very important when it comes to knowing whether or not to invest.
The income statement will be your guide when you’re trying to determine how profitable a company is. What might also surprise you is that the income statement can tell you a great deal about a company, in addition to just how much income it brings in.
Sizing up what a company has to its name
During times of intense financial stress, investors often make a very important mental shift. They’re not so concerned about making money as they are about just getting their money back. Similarly, when things get tough in the economy, investors are less interested in how profitable a company is and are more mindful of whether a company will survive the economic downturn.
When you’re trying to understand the lasting power of a company, fundamental analysis is of great value. By reading the company’s balance sheet, you can get a rundown of what a company has — its assets — and what is owes — its liabilities. Monitoring these items give you a very good picture of how much financial dry powder a company has to endure a tough period.
Burn baby burn: Cash burn
One of the biggest killers of companies, especially smaller firms just starting out, is poor cash flow. While a company might have a great product concept, excellent management, and even dedicated financial backers, timing is everything. If a company is using up cash to pay its bills and employees but not bringing in enough cold, hard cash from customers, it can run into a giant financial headache very quickly and not have enough cash to reach its potential.
Fundamental analysis helps you keep a close eye on how much cash is coming into and out of a company. Monitoring cash flow is critical to know if a company is running perilously empty on cash. Tracking a company’s cash flow is also a very important way fundamental analysis helps you put a price tag on that company.
Financial ratios: Your friend in making sense of a company
You might be a bit bewildered by just how many pieces of financial data fundamental analysts must deal with. You’ve got the financial statements that measure just about every aspect of the company. It can be intimidating to decide what numbers matter most and which ones can be ignored.
Financial ratios will be a great help here. These ratios draw all sorts of fundamental data from different sources and put them into perspective. Financial ratios are also important because they form the vocabulary of fundamental analysts.