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Type of Securities Investment Strategies Fundamental Analysis Technical Analysis
Introduction to Fundamental Analysis Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions


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

 


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.”

Medtronic, Inc.             
Consol. Statement of Earnings
($ in millions, except per share data)


Fiscal Yr.
2005


Fiscal Yr.
2004

Net sales

$ 10,054.6

$ 9,087.2

Costs and expenses:

 

 

     Cost of product sold

2,446.4

2,252.9

     Research and development exp.

951.3

851.5

     Selling, general and adm. exp.

3,213.6

2,801.4

     Purchased in-process R&D

 

41.1

     Special charges

654.4

(4.8)

     Other expenses, net

290.5

351.0

     Interest (income) / expense

(45.1)

(2.8)

          Total costs and expenses

7,511.1

6,290.3

 

 

 

Earnings before income taxes

2,543.5

2,796.9

Provision for income tax

739.6

837.6

Net earnings

$ 1,803.9
========

$ 1,959.3
========

 

 

 

Earnings per share:

 

 

     Basic

1.49

1.61

     Diluted

$ 1.48
========

$ 1.60
========

 

 

 

Weighted average shares outstanding:

 

 

     Basic

1,209.0

1,213.7

     Diluted

1,220.8

1,225.9

 

Medtronic, Inc.             
Income Statement Statistics

Fiscal Yr.
2005

Fiscal Yr.
2004

 

 

 

Price Earnings Ratio (“P/E Ratio”):

 

 

Year-end price – per share

$ 52.70

$ 50.46

Diluted Earnings – per share (“EPS”)

 1.48

 1.60

P/E Ratio

35.61 x

31.54 x

 

 

 

Net Profit Margins:

 

 

Net sales

10,054.6

9,087.2

Net earnings

1,803.9

1,959.3

Net profit margin percentage

17.94 %

21.56 %

 

 

 

R&D to Sales Ratio:

 

 

Net sales

10,054.6

9,087.2

Research and development expense

951.3

851.5

R&D as a percentage to sales

9.46 %

9.37 %

 

 

 

Return on Equity (“ROE”):

 

 

Net earnings

1,803.9

1,959.3

Average ending equity

9,763.3

8,491.7

ROE

18.48 %

23.07 %

 

 

 

Receivable Turnover:

 

 

Net sales

10,054.6

 

Average A/R

2,143.5

 

A/R turnover

4.7 x

 

Days sales uncollected

77.7 days

 

 

 

 

Inventory Turnover:

 

 

Cost of goods sold

2,446.4

 

Average inventory

929.6

 

Inventory turnover

2.6 x

 

Average days inventory on hand

140.4 days

 

Next review The Cash Flow Statement

 

 

.

 

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