Analyzing Company Reports

Fundamental Vs. Technical Analysis

Investors are always looking for a better way to pick securities. Two types of data analysis have
emerged to assist investors in making better investment decisions. In this section, we will
introduce you to fundamental and technical analysis.

What Is a Fundamental Analysis?

What Is a Technical Analysis?
Which Type of Analysis Is Better for You?

What Is a Fundamental Analysis?

Fundamental analysis is a method used to evaluate the worth of a security by studying the
financial data of the issuer. It scrutinizes the issuer's income and expenses, assets and liabilities,
management, and position in its industry. In other words, it focuses on the "basics" of the
business.

If you want to use fundamentals to help you make an investment decision, you would rely heavily
on an offering prospectus, annual and quarterly reports as well as any current news items relating
to the issuer whose securities you are considering.

A technical analysis takes a different approach.

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What Is a Technical Analysis?

Technical analysis is a method used to evaluate the worth of a security by studying market
statistics. Unlike fundamental analysis, technical analysis disregards an issuer's financial
statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a
security will perform.

If you want to use technical analysis to help you make an investment decision, you will refer to
financial charts, tables and ratios found in the financial press. You will look for market trends and
averages to help you decide whether the "time is right" to make an investment.

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Which Type of Analysis Is Better for You?

Fundamentalists and technicians have been at odds with one another since the advent of
investing. There is no clear answer as to which is right. Sometimes it appears that the technicians
make better picks. Other times it seems the fundamentalists are making the right call. One thing
is certain, when one group of analysts is wrong the other will surely emerge saying, "We told you
so." So, which is right for you? There are many potential answers to that question. Three variants
of popular answers are:
If you are a "long-term" investor looking for companies with solid foundation, growth and income
potential, the fundamentals may sway you.

If you are a "short-term" investor (trader) looking for companies who are "on the verge" of being
discovered, fundamentals will be useful to you.

If you are a "long-term" investor who is not as concerned about one company's basics because
you will diversify to minimize risk, or you are a "short-term" investor waiting for investor sentiment
to change, then technical analysis will be helpful to you.

Today, many investors find both fundamental and technical analysis helpful in painting a more
complete and colorful picture on the investment canvas. Whether you use an asset allocation,
buy and hold, or market timing strategy, you will find useful information from both the
fundamentalists and technicians. The technicians can tell you about the broad market and its
trends. The fundamentalists tell you whether an issue has the "basics" necessary to meet your
investment objectives.

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Concluding Remarks

Fundamental and technical analysis differ radically in their approaches. Which method has
yielded better returns over a suitable period of study has no clear answer. Nonetheless, by
familiarizing yourself with the tactics and techniques of each you will most likely be better suited
to make your own investment decisions. Try using the best ideas from each camp and you should
be pleased with the results.

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Reading Annual & Quarterly Reports

Reading Annual & Quarterly Reports

In the following section, we will look at the information available in corporate reports. We will
cover the following topics:

What Is an Annual Report and Why Is It Useful to Investors?

Required Information
How to Obtain Annual Reports
Quarterly and Other Financial Reports

What Is an Annual Report and Why Is it Useful to Investors?

A company is required by law to provide its shareholders with information about its operations. An
annual report satisfies this obligation.

The information in an annual report shows the company finances. It is extremely useful to
investors because it allows them to use their own judgment on how well the company is doing
and forecast its future earnings and dividends. For an investor, this information is critical for
making investment decisions.
You can also read the chairman's letter about the company's future goals. Use caution with these
letters since the author is a company representative. You may want to look at how accurate this
letter has been in the past to give you an idea how much you can trust it.

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Required Information

An annual report is a brief profile on the health of a company. Here is what comprises an annual
report:

A letter from the chairman on the high points of business in the past year with predictions
for the next year.
The company's philosophy: a section that describes how the company does business.
An extensive report on each section of operations in the company. This portion of the
report may describe the services or the products that the business offers.
Financial information that includes the profit and loss (P&L) statements and a balance
sheet. The P&L statement describes income and expenses and gives the net profit for the
year. The balance sheet describes assets and liabilities and compares them to the
previous year. In this section, important information may be revealed in the footnotes.
They may discuss current or pending lawsuits or government regulations that have an
impact on company operations.
An auditors' letter confirming that all of the information provided in the report is accurate
and has been certified by independent accountants.

Keep in mind that the public relations department of the company produces the annual report.
The report should be very accurate with all the information described in the best possible manner.

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How to Obtain Annual Reports

Annual reports are mailed automatically to all shareholders of record. To obtain the annual report
for a company in which you do not own shares, call the public relations (or shareholder relations)
department of the company. You may also look on the company Web site, or search the Internet.
There are several sources on the Internet providing information on public companies. You can
search the EDGAR database at www.sec.gov/edgarhp.htm, the Microsoft Investor Web site at
www.investor.msn.com, the American Association of Individual Investors at www.aaii.org, or the
Yahoo Financial Web site at finance.yahoo.com, to name a few. Simply keying in the stock's
symbol will provide you with the needed information.

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Quarterly and Other Financial Reports

Besides the annual report, companies provide several other financial reports such as a quarterly
report, 10k reports and statistical supplements.

Quarterly reports are very similar to the annual reports except they are issued every three
months and are less comprehensive. They may be obtained in the same way as an annual report.
Larger firms issue 10k reports that are more detailed than annual reports. A 10k report provides
detailed information about divisions and subdivision of the company. These reports are sent to
stockholders only by request. One should contact the company's corporate secretary to receive a
10k. All 10k filings are available on the EDGAR database at www.sec.gov/edgarhp.htm.

Statistical supplements are reports of larger corporations as well. They provide financial
information, such as statement data and key ratios, which can be dated back 10 to 20 years.
These reports are also posted on the EDGAR database (www.sec.gov/edgarhp.htm).

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Understanding Company Earnings

Understanding Company Earnings

In this section, you will learn about corporate earnings and why they are important to you as an
investor. You will learn what goes into corporate earnings and how to use earnings information to
make a decision about investing in a corporation. We will discuss the following topics:

What Are Company Earnings?

Why Are Earnings Important to You as an Investor?
What Makes Up Corporate Earnings?
Where Do You Find Corporate Earnings Information?
How Do You Use Earnings Information to Make an Investment Decision?

What Are Company Earnings?

Business 101: You go into business to make money. Unless an organization is a not-for-profit
enterprise, its goal is to make money for the owners. In order to make money, the business must
have income to pay its employees, utility bills, costs of production and other operating expenses.
If a company has cash left over after paying its expenses, it has earnings. Earnings are a
company's net profit.

The nature of a business defines how it makes earnings. Two sources of company earnings are
income from sales of goods or services and income from investment. For example, a
manufacturer produces goods for sale to its clients. A bank sells depository services to its clients.
All businesses generate income by providing either goods or services to clients.

Another source of income is investment. Investments generate income for businesses and
individuals from either interest on loans, dividends from other businesses, or gains on the sale of
investment property.

Company earnings are the sum of income from sales or investment after paying its expenses.
Sounds simple enough, but what does this have to do with you?

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Why Are Earnings Important to You as an Investor?

Remember from the previous lesson that people go into business to make money. Well, if you
invest in a company's stock, you gain an undivided share of the company. Typically, when a
company earns more money, shareholders do as well. So, company earnings are important to
you because you make money when the business you invest in makes money. When a company
you own stock in has positive earnings, it benefits you in several ways.

You may receive a portion of the earnings as a dividend.

The company may reinvest earnings for future growth.
The company may invest earnings to generate additional income.

In any case, earnings are important to you because they provide a company with capital to make
money for you as an investor.

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What Makes Up Corporate Earnings?

Income from sales and investments produce earnings.

Before a company can sell its product or service, it incurs expenses to produce them. These
expenses may include cost of materials, labor, market research, marketing, sales and distribution
and overhead. Before a company can show a profit, it must first settle the costs of doing
business.

The way in which a business conducts its operations is an important element to understand when
evaluating a company's earnings. Companies that are devoting significant resources to creating a
new product may have relatively weak earnings now. But, if that new product catches on, profits
could quickly rise and the earnings may begin to soar. Meanwhile, companies that have great
earnings now, but are not investing any money to ensure that their business success will
continue, may have significant problems in the future.

When evaluating corporate earnings you should not only look at the income sources, but the
expenses as well. They can reveal the company's long-term strategy for making money, or
uncover potential inefficiency or mismanagement.

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Where Do You Find Corporate Earnings Information?

The best place to learn about company earnings is the corporate annual report. The annual report
contains information on the company philosophy and its position in the marketplace. It also
contains audited financial statements. These tell you all about the company's financial operations.
You can obtain an annual report directly from the company's public relations department or on the
Web by searching the Securities and Exchange Commission's EDGAR database at
www.sec.gov/edgarhp.htm.

To find information about the company's earnings, you should study the "income statement" and
"balance sheet." The income statement shows the sources of a company's income, production
costs and other expenses. The balance sheet shows the company's overall financial strength and
potential for future growth. You can learn more about the financial statements in our sections on
Understanding Balance Sheets and Understanding Income Statements.
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How Do You Use Earnings Information to Make an Investment Decision?

How you use this information depends upon your investment goals. If you are an income investor,
you probably want to invest in a company that is paying dividends. If you are looking for long-term
growth, dividends may not be as important to you. The "financials" will show you whether a
company is oriented for income, growth, or a bit of both. You can get all of this information from
the financials. But you must compare the financials for different companies in the same industry
to see which has characteristics best suited to your investment goals.

A convenient way to compare companies is through earnings per share (EPS). EPS represents
the net profit divided by the number of outstanding shares of stock.

When comparing earnings per share of several companies that are candidates for your
investment dollars, here are a few things to consider.

Companies with higher earnings are stronger than companies with lower earnings.
Companies that reinvest their earnings may pay low or no dividends, but may be poised
for growth.
Companies with lower earnings, and higher research and development costs, may be on
the brink of a breakthrough (or disaster).
Companies with higher earnings, lower costs and lower shareholder equity, may be a
target for a merger.

When comparing different companies' earnings you should ask yourself,

Why are they different?

Do the differences make sense for these companies?

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Understanding Balance Sheets

Understanding Balance Sheets

In this section, we will learn the importance of balance sheets to you as an investor. We will cover
what they represent, how to understand them and how they are presented. We will also provide
some useful equations and an example of a balance sheet.

This section will cover the following topics:

Understanding the Balance Sheet

Why Should the Balance Sheet Be Important to You?
The Basic Concept Behind a Balance Sheet
What Are Assets?
What Are Liabilities?
What Is Shareholders' Equity?
Example of a Balance Sheet
Tying It All Together
Understanding the Balance Sheet

In order to make an informed investment decision, you should review a company's balance sheet.
Let's look at what a balance sheet entails.

The balance sheet is one of the most important financial statements of a company. It is reported
to investors at least once per year. It may also be presented quarterly, semiannually or monthly.
The balance sheet provides information on what the company owns (its assets), what it owes (its
liabilities), and the value of the business to its stockholders (the shareholders' equity). The name,
balance sheet, is derived from the fact that these accounts must always be in balance. Assets
must always equal the sum of liabilities and shareholders' equity.

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Why Should the Balance Sheet Be Important to You?

The balance sheet is the fundamental report of a company's possessions, debts and capital
invested. Before investing in any company, an investor can use the balance sheet to examine the
following:

Can the firm meet its financial obligations?

How much money has already been invested in this company?
Is the company overly indebted?
What kind of assets has the company purchased with its financing?

These are just a few of the many relevant questions you can answer by studying the balance
sheet. The balance sheet provides a diligent investor with many clues to a firm's future
performance. In this section, you will learn the basic building blocks necessary to do such
analysis. Once you completely understand the balance sheet, making informed investment
decisions should be much easier for you.

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The Basic Concept Behind a Balance Sheet

The concept behind the balance sheet is very simple. In order to acquire assets, a firm must pay
for them with either debt (liabilities) or with the owners' capital (shareholders' equity). Therefore,
the following equation must hold true:

Assets = Liabilities + Shareholders' Equity

Total Liabilities $30,000

Shareholders' Equity $50,000

Total Assets $80,000

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What Are Assets?

Assets are economic resources that are expected to produce economic benefits for its owners.
Assets can be buildings and machinery used to manufacture products. They can be patents or
copyrights that provide financial advantages for their holder. Let us begin with a look at a few of
the important types of assets that exist.

Current assets are assets that are usually converted to cash within one year. Bondholders and
other creditors closely monitor a firm's current assets since interest payments are generally made
from current assets. They include several forms of current assets:

Cash is known and loved by all. It is the most basic current asset. In addition to currency,
bank accounts without restrictions, checks and drafts are also considered cash due to the
ease in which one can turn these instruments into currency.
Cash equivalents are not cash but can be converted into cash so easily that they are
considered equal to cash. Cash equivalents are generally highly liquid, short-term
investments such as U.S. government securities and money market funds.
Accounts receivable represent money clients owe to the firm. As more and more
business is being done today with credit instead of cash, this item is a significant
component of the balance sheet.
A firm's inventory is the stock of materials used to manufacture their products and the
products themselves before they are sold. A manufacturing entity will often have three
different types of inventory: raw materials, works-in-process, and finished goods. A retail
firm's inventory generally will consist only of products purchased that have not been sold
yet.

Now that we have looked at some of the most important short-term assets, let us move forward to
examine long-term assets.

Long-Term Assets

Long-term assets are grouped into several categories. The following are some of the common
terms you may encounter:

Fixed assets are those tangible assets with a useful life greater than one year. Generally, fixed
assets refer to items such as equipment, buildings, production plants and property. On the
balance sheet, these are valued at their cost. Depreciation is subtracted from all except land.
Fixed assets are very important to a company because they represent long-term illiquid
investments that a company expects will help it generate profits.

Depreciation is the process of allocating the original purchase price of a fixed asset over the
course of its useful life. It appears in the balance sheet as a deduction from the original value of
the fixed assets.

Intangible assets are non-physical assets such as copyrights, franchises and patents. To
estimate their value is very difficult because they are intangible. Often there is no ready market
for them. Nevertheless, for some companies, an intangible asset can be the most valuable asset
it possesses.

Remember that every company will have different assets depending on its industry. However, it is
important to know and understand the major accounts that will appear on most balance sheets.
Now, we will talk about what the company owes to others: its liabilities.

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What Are Liabilities?

Liabilities are obligations a company owes to outside parties. They represent rights of others to
money or services of the company. Examples include bank loans, debts to suppliers and debts to
employees. On the balance sheet, liabilities are generally broken down into current liabilities and
long-term liabilities.

Current liabilities are those obligations that are usually paid within the year, such as accounts
payable, interest on long-term debts, taxes payable, and dividends payable. Because current
liabilities are usually paid with current assets, as an investor it is important to examine the degree
to which current assets exceed current liabilities.

The most pervasive item in the current liability section of the balance sheet is accounts payable.
Accounts payable are debts owed to suppliers for the purchase of goods and services on an
open account. Almost all firms buy some or all of their goods on account. Therefore, you will often
see accounts payable on most balance sheets.

Long-term debt is a liability of a period greater than one year. It usually refers to loans a
company takes out. These debts are often paid in installments. If this is the case, the portion to
be paid off in the current year is considered a current liability.

That wraps up our short review of liabilities. You only have one piece left of the balance sheet left
to learn - shareholders' equity. Remember that assets minus liabilities equals shareholders'
equity.

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What Is Shareholders' Equity?

Shareholders' equity is the value of a business to its owners after all of its obligations have been
met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of
capital the owners invested plus any profits that the company generates that are subsequently
reinvested in the company. This reinvested income is called retained earnings.

Now that we understand the major components, let us move forward to examine a sample
balance sheet.

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Example of a Balance Sheet

Below you will see an example of a balance sheet and the various components that you have
been studying earlier. The most important lesson to learn in viewing this example is that the basic
balance sheet equation holds true.

Assets = Liabilities + Shareholders' Equity

The following balance sheet is arranged vertically starting with assets and then proceeding to
detail liabilities and shareholders' equity. Note that the balance sheet gives a snapshot of the
assets, liabilities and equity for a given day. In our case, that is December 31. Often a balance
sheet shows information for two successive periods as the one below. This gives the investor a
better perspective of the company's operations by showing areas of growth.
 Pete's Potato & Pasta, Inc.
Balance Sheet Ending December 31st

1998 1999

ASSETS

Current Assets

Cash and cash

$10,000 10,000
equivalents

Accounts receivable 35,000 30,000

Inventory 25,000 20,000

Total Current Assets 70,000 60,000

Fixed Assets

Plant and machinery $20,000 20,000

Less depreciation -12,000 -10,000

Land 8,000 8,000

Intangible Assets 2,000 1,500

TOTAL ASSETS 88,000 79,500

LIABILITIES AND SHAREHOLDERS' EQUITY

Liabilities

Accounts payable $ 20,000 15,500

Taxes payable 5,000 4,000

Long-term bonds issued 15,000 10,000

TOTAL LIABILITIES 40,000 29,500

SHAREHOLDERS' EQUITY
Common stock $ 40,000 40,000

Retained earnings 8,000 10,000

TOTAL SHAREHOLDERS' EQUITY 48,000 50,000

LIABILITIES & SHAREHOLDERS' EQUITY $ 88,000 79,500

As you can see, total liabilities and shareholders' equity equals total assets.

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Tying It All Together

You have now learned the basic construction of a balance sheet and should have a clearer
understanding of its importance. The basic financial statement reveals what a company owns,
what a company owes to others, and the investments its owners made. It details how a company
finances its operations and what assets the company has acquired with this financing.

The key to understanding the balance sheet is in the most basic and fundamental of all
accounting equations: Assets must equal liabilities plus shareholders' equity. All of our further
balance sheet analysis will be based upon that building block.

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Balance Sheet Analysis

Balance Sheet Analysis

In this section, we will look at some of the tools you can use in making an investment decision
from balance sheet information. If you are not familiar with balance sheets, you are advised to
first read the section entitled, "Understanding the Balance Sheet". It provides a good overview of
the functions of a balance sheet and its components. We will cover the following topics here:

Why You Should Analyze a Balance Sheet

Liquidity Ratios
Leverage
Bankruptcy
Tying It All Together

A thorough analysis of a company's balance sheet is extremely important for both stock and bond
investors.

Why You Should Analyze a Balance Sheet

The analysis of a balance sheet can identify potential liquidity problems. These may signify the
company's inability to meet financial obligations. An investor could also spot the degree to which
a company is leveraged, or indebted. An overly leveraged company may have difficulties raising
future capital. Even more severe, they may be headed towards bankruptcy. These are just a few
of the danger signs that can be detected with careful analysis of a balance sheet.

Beyond liquidity and leverage, the following section will discuss other analysis such as working
capital and bankruptcy. As an investor, you will want to know if a company you are considering is
in danger of not being able to make its payments. After all, some of the company's obligations will
be to you if you choose to invest in it.

We will start with Liquidity Ratios, an important topic for all investors.

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Liquidity Ratios

The following liquidity ratios are all designed to measure a company's ability to cover its short-
term obligations. Companies will generally pay their interest payments and other short-term debts
with current assets. Therefore, it is essential that a firm have an adequate surplus of current
assets in order to meet their current liabilities. If a company has only illiquid assets, it may not be
able to make payments on their debts. To measure a firm's ability to meet such short-term
obligations, various ratios have been developed.

You will study the following balance sheet ratios:

Current Ratio
Acid Test (or Quick Ratio)
Working Capital
Leverage

These tools will be invaluable in making wise investment decisions.

Current Ratio

The Current Ratio measures a firm's ability to pay their current obligations. The greater extent to
which current assets exceed current liabilities, the easier a company can meet its short-term
obligations.

Current Assets

Current Ratio = ---------------------------

Current Liabilities

After calculating the Current Ratio for a company, you should compare it with other companies in
the same industry. A ratio lower than that of the industry average suggests that the company may
have liquidity problems. However, a significantly higher ratio may suggest that the company is not
efficiently using its funds. A satisfactory Current Ratio for a company will be within close range of
the industry average.

Acid Test or Quick Ratio

The Acid Test Ratio or Quick Ratio is very similar to the Current Ratio except for the fact that it
excludes inventory. For this reason, it's also a more conservative ratio.

Current Assets - Inventory

Acid test = ---------------------------

Current Liabilities

Inventory is excluded in this ratio because, in many industries, inventory cannot be quickly
converted to cash. If this is the case, inventory should not be included as an asset that can be
used to pay off short-term obligations. Like the Current Ratio, to have an Acid Test Ratio within
close range to the industry average is desirable.

Working Capital

Working Capital is simply the amount that current assets exceed current liabilities. Here it is in the
form of the equation:

Working Capital = Current Assets - Current Liabilities

This formula is very similar to the current ratio. The only difference is that it gives you a dollar
amount rather than a ratio. It too is calculated to determine a firm's ability to pay its short-term
obligations. Working Capital can be viewed as somewhat of a security blanket. The greater the
amount of Working Capital, the more security an investor can have that they will be able to meet
their financial obligations.

You have just learned about liquidity and the ratios used to measure this. Many times a company
does not have enough liquidity. This is often the cause of being over leveraged.

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Leverage

Leverage is a ratio that measures a company's capital structure. In other words, it measures how
a company finances their assets. Do they rely strictly on equity? Or, do they use a combination of
equity and debt? The answers to these questions are of great importance to investors.

Long-term Debt

Leverage = ----------------------

Total Equity

A firm that finances its assets with a high percentage of debt is risking bankruptcy should it be
unable to make its debt payments. This may happen if the economy of the business does not
perform as well as expected. A firm with a lower percentage of debt has a bigger safety cushion
should times turn bad.
A related side effect of being highly leveraged is the unwillingness of lenders to provide more debt
financing. In this case, a firm that finds itself in a jam may have to issue stock on unfavorable
terms. All in all, being highly leveraged is generally viewed as being disadvantageous due to the
increased risk of bankruptcy, higher borrowing costs, and decreased financial flexibility.

On the other hand, using debt financing has advantages. Stockholder's potential return on their
investment is greater when a firm borrows more. Borrowing also has some tax advantages.

The optimal capital structure for a company you invest in depends on which type of investor you
are. A bondholder would prefer a company with very little debt financing because of the lower risk
inherent in this type of capital structure. A stockholder would probably opt for a higher percentage
of debt than the bondholder in a firm's capital structure. Yet, a company that is highly leveraged is
also very risky for a stockholder.

When a firm becomes over leveraged, bankruptcy can result. Read on to learn more about this
dreaded occurrence.

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Bankruptcy

Bankruptcy is a legal mechanism that allows creditors to assume control of a firm when it can no
longer meet its financial obligations. Bankruptcy is a result feared by both stock and bond
investors. Generally, the firm's assets are liquidated (sold) in order to pay off creditors to the
extent that is possible. When bankruptcy occurs, stockholders of a corporation can only lose the
amount they have invested in the bankrupt company. This is called Limited Liability. The
stockholders' liability to creditors is limited to the amount invested. Therefore, if a firm's liabilities
exceed the liquidation value of their assets, creditors also stand to lose money on their
investments.

When bankruptcy occurs, a federal court official steps in and handles the payments of assets to
creditors. The remaining funds are always distributed to creditors in a certain pecking order:

1. Unpaid taxes to the IRS and bankruptcy court fees

2. Unpaid wages
3. Secured bondholders
4. General creditors and unsecured bonds
5. Subordinated debentures
6. Preferred Stockholders
7. Common Stockholders

Obviously, to hold secured bonds rather than unsecured bonds is more advantageous in the
event of a bankruptcy. This is where you must examine your risk/reward requirements. As you
move down this hierarchy, your risk of losing your investment increases. However, you are
"rewarded" for taking more risk with potentially higher investment returns.

How do you predict bankruptcy? Well, no one can do it perfectly. However, one popular method
called a Z-score (developed by Edward Altman) has a good track record. To learn more about "Z-
scores" go to your local library. We will recap a few of the most important points about learning to
analyze a company's balance sheet.

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Tying It All Together

Analyzing a balance sheet is fundamental knowledge for anyone who wishes to carefully select
solid and profitable investments. The balance sheet is the basic report of a firm's possessions,
debts and capital. The composition of these three items will vary dramatically from firm to firm. As
an investor, you need to know how to examine and compare balance sheets of different
companies in order to select the investment that meets your needs.

After reading this section, you should have an understanding of liquidity, leverage and bankruptcy
and know how to apply basic ratios to measure each. These ratios should be compared to other
firms in the same industry in order for them to have relevance. Be careful, however, that the firms
are not fundamentally different even if they are in the same industry.

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Understanding Income Statements

Understanding Income Statements

A company's income statement is a record of its earnings or losses for a given period. It shows
all of the money a company earned (revenues) and all of the money a company spent (expenses)
during this period. It also accounts for the effects of some basic accounting principles such as
depreciation.

The income statement is important for investors because it's the basic measuring stick of
profitability. A company with little or no income has little or no money to pass on to its investors in
the form of dividends. If a company continues to record losses for a sustained period, it could go
bankrupt. In such a case, both bond and stock investors could lose some or all of their
investment. On the other hand, a company that realizes large profits will have more money to
pass on to its investors.

In this section, we will cover the following:

Example of an Income Statement

Gross Profit on Sales
Operating Income
Earnings Before Interest and Taxes
Net Earnings (or Loss)
Retained Earnings
Income Statement Mnemonics
The Importance of the Income Statement to Investors

Example of an Income Statement

The income statement shows revenues and expenditures for a specific period, usually the fiscal
year. Income statements differ by how much information they provide and the style in which they
provide the information. Here is an example of a hypothetical income statement, with revenues in
black and expenditures in red (and parentheses):
 Wilma's Widgets Income Statements for the Years Ending
1998 and 1999

1998 1999

Sales $900,000 $990,000

Less Cost of Goods Sold (250,000) (262,500)

Gross Profit on Sales 650,000 727,500

Less General Operating Expenses (120,000) (127,500)

Less Depreciation Expense (30,000) (30,000)

Operating Income 500,000 570,000

Other Income 50,000 30,000

Earnings Before Interest and Tax 550,000 600,000

Less Interest Expense (30,000) (30,000)

Less Taxes (50,000) (54,500)

Net Earnings (Available Earnings for

470,000 515,500
Dividends)

Less Preferred and/or Common Dividends

(70,000) (80,000)
Paid

Retained Earnings 400,000 435,500

Now, as perplexing as those numbers might seem at first, you will become comfortable with them
very quickly once we explain what all this financial jargon really means. Let us start by looking at
the first term that was calculated - gross profit on sales.

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Gross Profit on Sales

Gross profit on sales (also called gross margin) is the difference between all the revenue the
company earns and the sales of its products minus the cost of what it took to produce them. Let
us move on to clarify how to calculate this important number.

Gross Profit on Sales = Net Sales - Cost of Goods Sold

Simple, yes, but let's be sure we know what the terms sales and costs of goods sold means to the
accountants.

Net sales are the total revenue generated from the sale of all the company's products or services
minus an allowance for returns, rebates, etc. Sometimes on an income statement, you might see
the terms "gross sales" and "returns," "rebates" or "allowances." Gross sales are the total
revenue generated from the company's products or services before returns or rebates are
deducted. Net sales on the other hand have all these expenses deducted.

Cost of goods sold is what the company spent to make the things it sold. Cost of goods sold
includes the money the company spent to buy the raw materials needed to produce its products,
the money it spent on manufacturing its products and labor costs.

When you subtract all the money a company spent in the production of its goods and services
(cost of goods sold) from the money made from selling them (net sales), you have calculated their
gross profit on sales.

Gross profit on sales is important because it reveals the profitability of a company's core
business. A company with a high gross profit has more money left over to pump into research and
development of new products, a big marketing campaign, or better yet - to pass on to its
investors. Investors should also monitor changes in gross profit percentages. These changes
often indicate the causes of decreases or increases in a company's profitability. For instance, a
decrease in gross profit could be caused by an industry price war that has forced the company to
sell its products at a lower price. Poor management of costs could also lead to a decreased gross
profit.

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Operating Income

Operating income is a company's earnings from its core operations after it has deducted its cost
of goods sold and its general operating expenses. Operating income does not include interest
expenses or other financing costs. Nor does it include income generated outside the normal
activities of the company, such as income on investments or foreign currency gains.

Operating income is particularly important because it is a measure of profitability based on a

company's operations. In other words, it assesses whether or not the foundation of a company is
profitable. It ignores income or losses outside of a company's normal domain. It also excludes
extraordinary events, such as lawsuits or natural disasters, which in a typical year would not
affect the company's bottom line.

An easy way to calculate operating income is as follows:

Operating Income = Gross profit - General Operating Expenses - Depreciation Expense

General operating expenses are normal expenses incurred in the day-to-day operation of
running a business. Typical items in this category include sales or marketing expenses, salaries,
rent, and research and development costs.

Depreciation is the gradual loss in value of equipment and other tangible assets over the course
of its useful life. Accountants use depreciation to allocate the initial purchase price of a long-term
asset to all of the periods for which the asset will be used.
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Earnings Before Interest and Taxes

Earnings before interest and taxes (EBIT) is the sum of operating and non-operating income.
This is typically referred to as "other income" and "extraordinary income" (or loss). As its name
indicates, it is a firm's income excluding interest expenses and income tax expenses. EBIT is
calculated as follows:

EBIT = Operating Income +(-) Other Income (Loss) +(-) Extraordinary Income (Loss)

Since we already know what operating income is, let's take a closer look at what other income
and extraordinary income mean.

Other income generally refers to income generated outside the normal scope of a company's
typical operations. It includes ancillary activities such as renting an idle facility or foreign currency
gains. This income may happen on an annual basis, but it is considered unrelated to the
company's typical operations.

Extraordinary income (or loss) occurs when money is gained (or lost) resulting from an event
that is deemed both unusual and infrequent in nature. Examples of such extraordinary
happenings could include damages from a natural disaster or the early repayment of debt.

Many companies may not have either other income or extraordinary income in a given year. If this
is the case, then earnings before income and taxes is the same as operating income. Regardless
of how it is calculated, EBIT is especially relevant to bondholders and other debtors who use this
figure to calculate a firm's ability to "cover" or pay its interest payments with its income for the
year.

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Net Earnings (or Loss)

Net earnings or net income is the proverbial bottom line. It measures the amount of profit a
company makes after all of its income and all of its expenses. It also represents the total dollar
figure that may be distributed to its shareholders. Net earnings are also the typical benchmark of
success. Just a reminder, however, many companies report net losses rather than net earnings.

How do we calculate net earnings?

Net Earnings = Earnings Before Interest and Taxes - Interest Expense - Income Taxes

Interest expense refers to the amount of interest a company has paid to its debtors in the current
year. Meanwhile, income taxes are federal and state taxes based upon the amount of income a
company generates. Often a company will defer its taxes and pay them in later years.

Net earnings are particularly important to equity investors because it is the money that is left over
after all other expenses and obligations have been paid. It is the key determinant of what funds
are available to be distributed to shareholders or invested back in the company to promote
growth.

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Retained Earnings

Retained earnings are the amount of money that a company keeps for future use or investment.
Another way to look at it is as the earnings left over after dividends are paid out. Generally, a
company has a set policy regarding the amount of dividends it will pay out every year. In this
case, 70% of net earnings become retained earnings.

Calculation of retained earnings:

Retained Earnings = Net Earnings - Dividends

To better understand retained earnings, we need to explain the nature of dividends. Dividends are
cash payments made to the owners or stockholders of the company. A profitable year allows them
to make such payments, although there generally are no obligations to make dividend payments.
When a company has both common and preferred stockholders, the company has two different
types of dividends to pay.

Every publicly traded company has common stockholders. Dividend payments to common
stockholders are optional and up to each company to decide how (or if) it will make such
payments. A firm may decide to plow all of its earnings into new investments to promote future
growth. Preferred stockholders are in line before common stockholders if a dividend is declared.
However, not all companies have preferred stockholders.

As an investor, it is important to know what a company does with its net earnings. An investor
needs to know the company's dividend and retained earnings policies to decide whether the
company's objectives are in line with the investor's. If the company pays dividends it is income-
oriented. If it retains earnings for future expansion, it is growth-oriented.

Knowing the sources of income and expenses is necessary when reading an income statement.
Two helpful mnemonic devices have been created out of the major components of the income
statement.

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Income Statement Mnemonics

Although these mnemonics may not account for every line on an income statement, these two will
help you remember the major parts, and the order in which they appear. The word "SONAR"
identifies the major sales and earnings. The word "EDIT" summarizes major expenditures.

As you look vertically down the first row of letters, you should discover the spelling of "SONAR."
The vertical set of letters in the second column spells out "EDIT."

S = Sales (gross)

E = Less expenses (general operating expenses and cost of goods sold)

D = Less depreciation

O = Operating income (before interest and taxes)

I = Less interest
T = Less taxes
N = Net earnings
A = Available earnings for common stock
R = Retained earnings

Let's conclude with a review of the importance of the income statement for investors.

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The Importance of the Income Statement to Investors

The income statement provides the investor with much insight to the company's revenues and
expenses. You can identify where the company spends much of its income and compare that to
similar companies. You can also compare a company's performance with previous years. Most
importantly, the income statement tells an investor if the business is profitable. If the company
continually makes substantial profits, it indicates to bondholders that it is a stable company. The
savvy investor will compare income statements of similar companies.

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Income Statement Analysis

Income Statement Analysis

The income statement is a basic record for reporting a company's earnings. Since earnings are a
fundamental component in a firm's worth, it is essential for investors to know how to analyze
different elements of this important document.

This section is designed to teach you some basic methods for analyzing the income statement.
Analyzing income statements is an important tool to help investors appraise their investment
options. By analyzing an income statement properly, investors can begin to evaluate the
effectiveness of the management of operations in the companies in which they are interested in
investing. Proper income sheet analysis can help identify good investment opportunities. It can
also reduce the risk involved with choosing a poor investment choice.

In this section, we introduce you to the following ratios, tools and concepts to help you analyze
income statements:

Interest Coverage
Profitability Ratios
Where Did All Those Expenses Come From?
Depreciation Expense
Basic Points about Calculating Depreciation
Straight-Line Depreciation
Acclerated Depreciation
Selecting a Depreciation Method

Interest Coverage (a.k.a. Times Interest Earned)

Interest Coverage is the measurement of how many times interest payments could be made with
a firm's earnings before interest expenses and taxes are paid. From a bondholder's perspective,
interest coverage is a test to see whether a firm could have problems making their interest
payments. From an equity holder's perspective, this ratio helps to give some indication of the
short-term financial health of the company.

The following formula is used to determine the coverage of interest:

Earnings Before Interest and

Taxes (EBIT)

Interest Coverage Ratio = ----------------------------

Interest Expense

A higher ratio is typically better for bondholders and equity investors. For bondholders a high ratio
indicates a low probability that the firm will go bankrupt in the near term. A company with a high
interest coverage ratio can meet their interest obligations several times over. Stock investors
typically like companies with high interest coverage ratios too. A high ratio indicates a company
that is probably relatively solvent. Thus, all other things equal, an investor should be very careful
with firms that have a low Interest Coverage Ratio with respect to other companies in their
industry.

Since the fundamental purpose of the income statement is to report profits or losses,
understanding the various profitability ratios that follow is extremely helpful to your analysis of a
firm.

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Profitability Ratios

Profitability is often measured in percentage terms in order to facilitate making comparisons of a

company's financial performance against past year's performance and against the performance of
other companies.

When profitability is expressed as a percentage (or ratio), the new figures are called profit
margins. The most common profit margins are all expressed as percentages of Net Sales.

Let's look at a few of the most commonly used profit margins that you can easily learn to use to
help you measure and compare firms:

Gross Margin is the resulting percentage when Gross Profit is divided by Net Sales. Remember
that Gross Profit is equal to Net Sales - Cost of Goods Sold. Therefore, Gross Margin represents
the percentage of revenue remaining after Cost of Goods Sold is deducted. Let us take a look at
a simple example.

Net Sales = $1,000

Cost of Goods Sold = $400

Gross Profit = $600

Gross Profit

Gross Margin = --------------------------

Net Sales

In this example the Gross Margin = 600/1000 = .60 or 60%

Since this ratio only takes into account sales and variable costs (costs of goods sold), this ratio is
a good indicator of a firm's efficiency in producing and distributing its products. A firm with a ratio
superior to the industry average demonstrates superior efficiency in its production processes. The
higher the ratio, the higher the efficiency of the production process. Investors tend to favor
companies that are more efficient.

Operating Margin. As the name implies, operating margin is the resulting ratio when Operating
Income is divided by Net Sales.

Operating Income

Operating Margin = --------------------------

Net Sales

This ratio measures the quality of a firm's operations. A firm with a high operating margin in
relation to the industry average has operations that are more efficient. Typically, to achieve this
result, the company must have lower fixed costs, a better gross margin, or a combination of the
two. At any rate, companies that are more efficient than their competitors in their core operations
have a distinct advantage. Efficiency is good. Advantages are even better. Most investors will
tend to prefer a more efficient company.

Let's move on to the last profitability measure we will cover in this section.

Net Margin. As the name implies, Net Margin is a measure of profitability for the sum of a firm's
operations. It is equal to Net Profit divided by Net Sales:

Net Profit

Net Margin = ---------------

Net Sales

As with the other ratios you will want to compare Net margin with other companies in the industry.
You can also track year-to-year changes in net margin to see if a company's competitive position
is improving, or getting worse.

The higher the net margin relative to the industry (or relative to past years), the better. Often a
high net margin indicates that the company you are looking at is an efficient producer in a
dominant position within its industry. However, as with all the previous profit margin
measurements, you need to always check past years of performance. You want to make sure that
good results are not a "fluke." Strong profit margins that are sustainable indicate that a company
has been able to consistently outperform their competitors.

The saavy investor uses profitability margins to help analyze income statements of prospective
investments. Companies with high interest coverage ratios, gross margins, operating margins and
net margins will always be very attractive to investors.

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Where Did All Those Expenses Come From?

You have just finished learning about interest coverage and profitability ratios. Both of these
measures are simple and easy to understand. Interest coverage measures a company's ability to
make its loan payments. Profitability ratios measure the bottom line of the income statement -
earnings.

However, to calculate either ratio, you must be able to classify a company's expenses. The
interest coverage ratio concerns itself with a specific type of expense (interest expense).
Meanwhile, profitability ratios such as net profit margin consider the net effect of all the expenses
a company incurs.

Most of the expenses a company incurs (raw materials, labor, rent, etc.) are straightforward
items. In general, companies want to minimize these sorts of expenditures to ensure improved
performance and profitability. For example, the less a company has to pay for the raw materials of
the products it produces, the more competitive that company can become.

Yet, there is one type of expense companies cannot eliminate. In fact, incurring this expense
actually helps save the company money. What is this mysterious expense?

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Depreciation Expense

Depreciation is the process by which a company gradually records the loss in value of a fixed
asset. The purpose of recording depreciation as an expense over a period is to spread the initial
purchase price of the fixed asset over its useful life.

Each time a company prepares its financial statements, it records a depreciation expense to
allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike
other expenses, depreciation expense is a "non-cash" charge. This simply means that no money
is actually paid at the time in which the expense is incurred.

Like all other expenses, depreciation expense reduces the taxable income of the company. Yet, a
business reporting a depreciation expense incurs no additional cash expenditure. Simply put,
depreciation allows businesses to reduce their taxable income without making the additional cash
expenditure typical of most other expenses.

While depreciation is an attractive way to reduce taxable income, specific regulations govern how
it is to be calculated and allocated. Let's take a moment to review a few important points about
how companies calculate depreciation.
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Basic Points about Calculating Depreciation

When analyzing income statements, it is very important to understand how different accounting
methods for calculating depreciation affect the income statement. Sometimes the accounting
methods selected can materially alter the net result of this important statement.

Most businesses have the right to choose amongst a number of different depreciation schedules.
Typically, businesses elect a depreciation schedule to suit their specific needs or preferences. In
order to make comparisons of different companies, you will need to know the role that accounting
plays in the final composition of their respective income statements.

A company can choose from several methods (or depreciation schedules) to calculate its
depreciation expense. Read below to look at two of the most common methods.

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Straight-Line Depreciation

Straight-line Depreciation is the simplest and most commonly used accounting method for
depreciation. Basically, the straight-line depreciation method calculates the amount of annual
depreciation expense that is to be recorded by dividing the value of the asset (as determined by
its purchased price) by its useful life. Often some adjustment is made for the anticipated "residual
value" that the asset may have at the end of its "useful life."

The IRS provides taxpayers with a depreciation schedule that defines what the useful life of
different types of assets (cars, computers, etc.) are to be. Thus, an item that has a relatively
short-lived useful life (such as a computer) may be able to be depreciated more quickly than an
asset (such as a building) that has a long and useful life expectancy ahead of it.

Using a straight-line depreciation schedule, businesses deduct the same amount of depreciation
each year until the assets has been fully depreciated.

However, straight-line depreciation is not the only method available. Let's look at another popular
option.

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Accelerated Depreciation Methods

Accelerated Depreciation Methods are also a very common way for companies to allocate their
depreciation expenses. These methods are those methods that are utilized to write off
depreciation costs more rapidly than the straight-line method.

Various accelerated methods exist. Two popular methods of accelerated depreciation are Sum-of-
the-Years'-Digits and Double Declining Balance. These methods are more complex in nature and
we will not delve into their calculations at present.

However, the important thing to know is that each of these methods record depreciation expense
more heavily in the current years in comparison to the straight-line method. By recording more
expense in the early stages of an assets useful life, accelerated depreciation methods reduce the
taxable income for those years and thus reduce income taxes for those years. However, in later
years, accelerated depreciation methods will record less depreciation, leaving more income. The
company will therefore have to pay greater taxes.

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Selecting a Depreciation Method

For the company, the choice of depreciation method will depend on a company's current financial
situation and/or its own preferences. Companies that wish to defer current taxable income may
elect accelerated depreciation methods to accomplish this goal. However, companies that need to
show large earnings in the current year may elect to forgo accelerated depreciation methods and
opt for a straight-line method. Both methods have their advantages and disadvantages. Typically,
a company is free to choose the method that best suits its preferences.

However, as an investor, you will likely not have the power to tell the company what method to
use. Instead you will need to know how each of these different methods can alter an income
statement. If you can do this, you will be able to evaluate how a company's depreciation schedule
impacts the value of the investment opportunity.

When making comparisons of different companies, you should always check to see if they use
the same accounting methods. If not, you will want to make an adjustment in order to effectively
compare these companies.

At first, comparing depreciation methods and accounting rules may seem daunting. However, with
a little practice you will be armed and ready to really understand the companies you are
interested in investing in.

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Concluding Remarks

Now that you have completed this section, you should be familiar with some basic methods to
help you evaluate different investment options.

Using the analysis techniques that we have introduced, you have a good basis of knowledge from
which to make informed investment decisions. Remember that the main purpose of the income
statement is to report profitability. Because profitability is crucial in any investment decision,
knowing some basic techniques of how to analyze the income statement should be a very
important part in your development as an informed investor.

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Calculating Profitability Ratios

Calculating Profitability Ratios

Corporate earnings are important to you as an investor. If you compare corporate earnings of
prospective investments, you will make wiser investment decisions. Profitability ratios provide you
with tools you can use to make these comparisons.

In this section you will learn:

How Do I Use Fundamentals to Make an Investment Decision?

What Is Ratio Analysis?
What Can I Learn from Profitability Ratios?
When Is an Increase in Earnings a Loss?
How to Use Profitability Ratios to Make Investment Decisions
Other Ratios to Consider

How Do I Use Fundamentals to Make an Investment Decision?

Fundamental analysis is a method used to evaluate the worth of a security by studying the
financial data of the issuer. Performing fundamental analysis will teach you a lot about a
company, but virtually nothing about how it will perform in the stock market. Apply this analysis on
two competing companies and it becomes clearer which is the better investment choice. In this
section, you will learn to use some of the tools of the fundamental analyst.

As an investor, you are interested in a corporation's earnings because earnings provide you with
potential dividends and growth. Companies with greater earnings pay higher dividends and have
greater growth potential. You can use profitability ratios to compare earnings for prospective
investments. Profitability ratios are measures of performance showing how much the firm is
earning compared to its sales, assets or equity.

You can quickly see the difference in profitability between two companies by comparing the
profitability ratios of each. Let us see how ratio analysis works.

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What Is Ratio Analysis?

While a detailed explanation of ratio analysis is beyond the scope of this section, we will focus on
a technique, which is easy to use. It can provide you with a valuable investment analysis tool.

This technique is called cross-sectional analysis. Cross-sectional analysis compares financial

ratios of several companies from the same industry. Ratio analysis can provide valuable
information about a company's financial health. A financial ratio measures a company's
performance in a specific area. For example, you could use a ratio of a company's debt to its
equity to measure a company's leverage. By comparing the leverage ratios of two companies,
you can determine which company uses greater debt in the conduct of its business. A company
whose leverage ratio is higher than a competitor's has more debt per equity. You can use this
information to make a judgment as to which company is a better investment risk.

However, you must be careful not to place too much importance on one ratio. You obtain a better
indication of the direction in which a company is moving when several ratios are taken as a
group.

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What Can I Learn from Profitability Ratios?

The profitability ratios include: operating profit margin, net profit margin, return on assets and
return on equity.

Profit margin measures how much a company earns relative to its sales. A company with a
higher profit margin than its competitor is more efficient. There are two profit margin ratios:
operating profit margin and net profit margin. Operating profit margin measures the earnings
before interest and taxes, and is calculated as follows:

Operating Profit Margin = Earnings Before Interest and Taxes

Sales

Net profit margin measures earnings after taxes and is calculated as follows:

Net Profit Margin = Earnings After Taxes

Sales

While it seems as if these both measure the same attribute, their results can be dramatically
different due to the impact of interest and tax expenses. Similarly, the next two ratios appear to be
similar but they tell different stories. As an investor, you are interested in getting a return on your
investment. So is a corporation.

Return on assets (ROA) tells how well management is performing on all the firm's resources.
However, it does not tell how well they are performing for the stockholders. It is calculated as
follows:

Return on Assets = Earnings After Taxes

Total Assets

Return on equity (ROE) measures how well management is doing for you, the investor, because
it tells how much earnings they are getting for each of your invested dollars. It is calculated as
follows:

Return on Equity = Earnings After Taxes

Equity
These ratios are easy to calculate and the information is readily available in a company's annual
report. All you need do is review the income statement and balance sheet to come up with the
data to plug into the formulas.

But, do not neglect other income statement information that can save you from making a costly
mistake.

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When Is an Increase in Earnings a Loss?

Sometimes an increase in company earnings can disguise an operating loss. If a company's

operating expenses exceed its operating income, it has an operating loss. If it also has income
from investments and tax benefits, this income can offset the loss and show an increase in
earnings per share. However, if these other sources of non-operating income are not recurring,
the unsuspecting investor may come to an erroneous conclusion about the company's overall
financial health. The lesson to be learned here is to carefully scrutinize the financials especially
when operating income is negative.

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How to Use Profitability Ratios to Make Investment Decisions

When considering a company as a prospective investment you should review its financial
statements. Pay particular attention to the profitability ratios. If you can, calculate the ratios for the
same company over several successive years to see if the company earnings are consistent,
growing, or declining.

Compare your candidate's ratios to other companies in the same industry. This will help you
determine where your candidate stands in the industry.

Do not ignore other financial information on the income statement and balance sheet. Pay
particular attention to losses in income items.

For more information on financials, see the sections on Understanding Balance Sheets and
Understanding Income Statements.

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Other Ratios to Consider

Price to Earnings Ratio (P/E)

The price to earnings ratio, or P/E, is figured by dividing the stock price by the company's
earnings per share (EPS). The P/E is a performance benchmark that can be used as a
comparison against other companies or within the stock's own historical performance. For
instance, if a stock has historically run at a P/E of 35 and the current P/E is 12, you will want to
explore the reasons for the drastic change. If you believe that the ratio is too low, you may want to
buy the stock.

You will generally find a P/E ratio based on either the prior reporting year's earnings, or the
earnings of the prior four quarters added together. This latter number is referred to as LTM or
Latest Twelve Months. While this is useful for understanding the history of a company, most
analysts prefer to view a forward-looking P/E ratio. This ratio is calculated by dividing the stock
price by the analysts' earnings estimate for the next year or two.

One other note on P/E Ratios. Sometimes, when a company is not doing well, it will buy back
shares so that the EPS and P/E Ratio will appear better. This can be seen in the example below.

Example 1 Example 2

Net Income $1,000,000 $1,000,000

Shares Outstanding 10,000,000 8,000,000

Earnings Per Share (EPS) $0.10 $0.125

Stock Price $3.00 $3.00

P/E Ratio 30 24

In the table above, the only change from Example 1 to Example 2 is in the number of shares
outstanding. The net income and stock price remain the same. However, by changing the shares
outstanding, the EPS has changed quite a bit. This means that the P/E ratio has also changed. At
first glance, if a stock's EPS has increased 25% and its P/E ratio has gone from 30 to 24 it might
look like a better buy. However, the truth is that nothing has changed but the number of shares.
The stock is not a better buy in Example 2 than it was in Example 1.

Where P/E Does Not Apply

When looking at newer companies such as Internet start-ups or bio-techs, there is often no net
income, so there are no earnings per share. In these cases the P/E ratio does not apply, forcing
analysts to turn to other measures. The most common alternative ratios include: revenues per
share, gross income per share or cash flow per share. All these ratios take the relevant number
from an income statement, divide them by the number of shares and then divide the stock price
by this number.

For example if XYZ Corp. has sales of $1 billion and 100 million shares outstanding, then the
revenue per share is $10. If the stock is trading at $90 per share, the price to revenue ratio is 9x.
There are flaws in taking these ratios, but in the absence of a meaningful P/E Ratio, they are a
good place to start.

Current Ratio

The current ratio provides an indication of how liquid a company may be in the coming year. To
calculate it, take the current assets and divide that number by the current liabilities. You will find
all of these figures on the balance sheet.

An answer of 1.0 or better is generally considered good. However this, like other ratios, can
depend on a company's current stage of growth. A start-up company should have a lower ratio
than an established company. If it does not, then you will want to ask yourself why and do further
research.

A current ratio can also be affected by how much long-term debt a company has in relation to its
short-term debt. Some companies prefer to use short-term debt and reissue it more often. Other
companies minimize their use of short-term debt. Most companies use a mix depending on what
is available to them, what is cheaper at the moment and how their economists project interest
rates for the future. Hence, this ratio also needs to be used to build a bigger picture rather than in
isolation.

Long-Term Debt to Equity

The long term debt to equity ratio can tell you how much debt a company is using to finance its
operations. If this number is too high it may signify future liquidity problems. If this number is too
low it can signify inefficient use of the financing alternatives available to a company.

This ratio is calculated by taking the long-term debt of a company and dividing it by the
shareholders' equity. Be sure to include the company's lease obligations (which can be found in
detail in the footnotes of an annual report) when calculating long-term debt.

Start up companies which have access to the debt markets, often have higher ratios than more
established companies. In addition, the amount of debt a company can safely issue varies by
industry. For example, companies with large manufacturing facilities often have more long-term
debt than companies that provide services or software. Therefore, it is useful to look at the ratios
of numerous companies in the same industry before drawing any conclusions.

Total Debt to Equity

Since companies can affect either the current ratio or the long-term debt to equity ratio by altering
their mix of short-term and long-term debt, this ratio can often be more useful than the other two.
This ratio is calculated by dividing all long-term debt, short-term debt and lease obligations by the
shareholders' equity.

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How Analysts Present Their Findings

How Analysts Present Their Findings

The study of all this data is known on Wall Street as fundamental analysis. Most analysts would
view themselves as fundamental analysts, meaning they make investment decisions based on
the available information about a company.

After going through the history of the ratios above, other ratios not explained here and the non-
financial information available on a company (product, strategy, marketing, management, etc.),
the analysts build models that project what will happen to a company in the future. Based on
these models they issue two pieces of information.

The first piece of information you will likely see is an analyst's projected earnings per share (EPS)
for a company. Projections for many companies are available online, where you can see the
mean or average projection as well as the extreme projections and the recent movement in the
projections.

Since investors rely on analysts to filter the information provided, when analysts change these
projections, it will often affect the price of the stock. In other words, the analysts' projections act
as an information source in their own right. When an analyst lowers an earnings projection for a
company, people assume they have learned something negative about a company's future
performance. As a result, they believe a company is less valuable and sell their stock.
Conversely, when an analyst raises their earnings projection, people believe they have learned
something positive about the future of a company. In this case investors will view the company as
more valuable and proceed to buy the stock.

An analyst also makes their own buy or sell recommendation, often including a target stock price.
While many firms use synonyms for the following terms, these are the basic recommendation
levels:

Strong buy - Investors are strongly encouraged to buy a stock with this recommendation.

Buy - Buying a stock with this recommendation is suggested, but with a little less emphasis.

Accumulate - Investors are advised to buy a stock with this recommendation steadily over time.

Hold - Investors are advised neither to buy nor sell, but if you are a pessimist reading between
the lines, this might be construed as a signal to sell.

Sell - The analyst recommends that investors unload this stock.

When Is The Right Time To Buy?

Once you have found an investment idea, researched it thoroughly and have done a detailed
analysis, it will be time to make a decision. If an individual stock seems to have good prospects, if
it fits your portfolio and if the risk is acceptable, the time may be right to buy the stock.

The decision on when to buy is yours alone.