Fundamental Analysis
How to read a company's financial statements, the ratios that matter, how valuation works in outline, and the red flags that appear before a loss.
Fundamental Analysis coming soon. Follow us on YouTube in the meantime.
Fundamental analysis is the study of a business rather than its share price. The question is not “will this stock go up”, it is “what does this company earn, what does it own, what does it owe, and what is a reasonable price to pay for a share of that”.
It is a set of tools for forming a view, not a method for predicting a price. Two careful analysts can read the same accounts and reach different valuations, and both can be wrong about the next year.
This lesson covers the three financial statements, the ratios worth knowing, how the statements connect, where earnings quality hides, valuation in outline, and the warning signs that appear in the accounts before they appear in the news.
The three statements
A listed Indian company publishes three statements every quarter, and a full set every year.
The statement of profit and loss (P&L) covers a period, usually a quarter or a year. It starts with revenue, subtracts the cost of goods sold and operating expenses to reach operating profit, then subtracts depreciation, interest and tax to reach net profit. It tells you whether the business made money on its operations.
The balance sheet is a snapshot on one date. It lists what the company owns (assets), what it owes (liabilities), and the difference (shareholders’ equity). The accounting identity is:
Assets = Liabilities + Shareholders’ equity
The cash flow statement covers the same period as the P&L and reconciles profit to cash. It has three parts: operating activities (cash from running the business), investing activities (capital expenditure, acquisitions, sale of assets), and financing activities (borrowing, repayment, dividends, share issuance).
The single most useful habit in fundamental analysis is to read the cash flow statement alongside the P&L. Profit is an accounting number. Cash is what pays bills.
How the statements connect
The three statements are one system, not three documents.
- Net profit from the P&L increases retained earnings on the balance sheet.
- Depreciation reduces profit in the P&L and reduces the book value of fixed assets on the balance sheet.
- Capital expenditure appears in the investing section of the cash flow statement and adds to fixed assets on the balance sheet.
- Borrowing appears in financing cash flow and adds to debt on the balance sheet.
- Interest on that debt appears in the P&L.
If you change one number, the others move. That is why a company cannot simply “improve profit” without the change showing somewhere else.
A worked example
Take a hypothetical company, XYZ Ltd, with these figures for a year, all in crore rupees.
| Line | Amount |
|---|---|
| Revenue | 1,000 |
| Operating expenses (including cost of goods sold) | 800 |
| EBITDA | 200 |
| Depreciation | 50 |
| Interest | 30 |
| Profit before tax | 120 |
| Tax at 25% | 30 |
| Net profit | 90 |
| Shares outstanding | 10 crore |
| Share price | ₹180 |
| Shareholders’ equity | 450 |
| Total debt | 150 |
| Cash | 50 |
| Operating cash flow | 110 |
| Capital expenditure | 40 |
From these:
- EPS = 90 / 10 = ₹9 per share.
- P/E = 180 / 9 = 20 times.
- Market capitalisation = 180 × 10 crore = ₹1,800 crore.
- Enterprise value = 1,800 + 150 − 50 = ₹1,900 crore.
- ROE = 90 / 450 = 20%.
- EBIT = 200 − 50 = ₹150 crore.
- Capital employed = 450 + 150 − 50 = ₹550 crore.
- ROCE = 150 / 550 = 27.3%.
- Debt to equity = 150 / 450 = 0.33.
- Interest coverage = 150 / 30 = 5 times.
- Free cash flow = 110 − 40 = ₹70 crore.
- Cash conversion = 110 / 90 = 1.22.
None of these numbers tells you to buy or sell. Together they describe a business that earns a 20% return on equity, carries modest debt, covers its interest five times, and converts profit into cash at a rate above one. That is a description, and the price you pay for it is a separate question.
The ratios that matter
There are hundreds of ratios. Most are variations of a few ideas. These are the ones worth knowing first.
| Ratio | How it is calculated | What it tells you | What it does not tell you |
|---|---|---|---|
| P/E | Price per share / EPS | What the market pays for each rupee of current earnings | Whether those earnings will persist |
| P/B | Price per share / book value per share | Price relative to accounting net worth | Whether the assets are worth their book value |
| ROE | Net profit / shareholders’ equity | Return generated on owners’ capital | How much debt is used to generate it |
| ROCE | EBIT / capital employed | Return on all long-term capital, debt and equity | The cost of that capital |
| Debt to equity | Total debt / shareholders’ equity | Financial leverage | Whether the debt is short or long term |
| Interest coverage | EBIT / interest expense | How many times operating profit covers interest | Whether cash is available to pay it |
| Current ratio | Current assets / current liabilities | Short-term liquidity | The quality of the current assets |
| Dividend yield | Dividend per share / price | Cash returned to shareholders | Whether the dividend is sustainable |
Two cautions on P/E, because it is the most quoted and the most misused.
First, P/E uses trailing earnings unless you are told otherwise. A “forward P/E” uses an estimate, and an estimate is an opinion. Second, a low P/E can mean a cheap business or a business the market expects to shrink. The ratio alone cannot tell you which.
ROE has a similar trap. A company can raise its ROE by borrowing more, because the equity base stays the same while profit rises. Always read ROE beside debt to equity and interest coverage.
Earnings quality
Two companies can report the same profit and be in very different health. The differences show up in a few places.
Cash conversion. Compare operating cash flow to net profit over several years. A business that consistently converts profit into less cash than it reports is either growing working capital quickly or recognising revenue it has not collected.
Receivables. If trade receivables grow faster than revenue for several quarters, the company may be selling on longer credit to keep growth up. That is not automatically wrong, but it deserves an explanation.
Inventory. For a manufacturer or retailer, inventory growing faster than sales can signal unsold stock. For a commodity business, it can also reflect higher input prices, so read it with the margin trend.
One-off items. Look for “exceptional” gains or losses, asset sales, and write-offs. A company that reports an exceptional item every year is not having an exceptional year.
Related-party transactions. These are dealings with entities connected to the promoters or directors. They are legal and often ordinary, but they need to be disclosed and read. A company buying from or selling to a promoter-owned entity at unusual terms is a question, not automatically a fraud.
Valuation in outline
Valuation is the attempt to put a number on a business. There are two broad families.
Relative valuation compares the company to similar businesses. If peers trade at 15 to 25 times earnings and this one trades at 18, it is within the range. The method is quick and widely used, and it inherits the market’s mood: if the whole sector is expensive, the comparison will call an expensive company fair.
Intrinsic valuation tries to estimate the present value of the cash the business will produce. A discounted cash flow (DCF) model projects free cash flow for several years, discounts it back at a rate that reflects risk, and adds a terminal value. The output is only as good as the assumptions: a one percentage point change in the discount rate or the terminal growth rate can move the answer by a large fraction. A DCF is a way of making your assumptions explicit, not a machine that produces the true price.
Whichever method you use, the useful discipline is the margin of safety: buy only when the price is meaningfully below your estimate of value, so that being wrong by a reasonable amount does not lose you money.
Sectors are not comparable
A ratio means different things in different industries, and comparing across them produces nonsense.
- Banks and NBFCs: debt is the raw material, not a warning sign. Read net interest margin, gross and net non-performing assets, provision coverage, capital adequacy and loan growth. A bank with a low debt-to-equity ratio is not automatically safer; it may simply be small.
- Manufacturers: read capacity utilisation, inventory days, receivable days, capital expenditure and the operating margin cycle.
- IT services: read revenue growth in constant currency, attrition, utilisation, deal wins and the margin effect of wage increases.
- Commodity producers: read realisations, unit costs and the position in the price cycle. A low P/E at the top of a commodity cycle can be the most expensive time to buy.
Red flags worth reading
These are not proof of wrongdoing. They are questions that deserve an answer before you invest.
- Promoter pledging. Shares pledged as collateral for the promoters’ own borrowing can be sold if the price falls, which adds selling pressure at the worst time.
- Frequent auditor changes or resignations. A change can be routine. A resignation with a qualified opinion or a delay in filing is not.
- Restatements. A company that restates accounts more than once has a controls problem, whatever the explanation.
- Receivables and inventory outrunning revenue, as above.
- Related-party transactions that are large relative to the business, especially loans to promoter entities.
- Contingent liabilities that are large relative to net worth: tax disputes, guarantees, litigation.
- Cash that never appears as a dividend, buyback or acquisition. A large cash balance that sits idle for years is either conservative or not really there.
Where to read it
- The annual report, which contains the audited statements, the notes, the auditor’s report, the management discussion and the corporate governance report.
- Quarterly results and investor presentations, filed with the exchanges.
- The company’s filings on the NSE and BSE websites, which are the primary record.
- The Ministry of Corporate Affairs (MCA) portal, for the statutory filings of Indian companies.
Read the notes, not only the headline numbers. The notes carry the accounting policies, the related-party disclosures, the contingent liabilities and the segment information. Most of the interesting questions are answered there.
What fundamental analysis cannot do
It cannot tell you when the price will move. A cheap stock can stay cheap for years, and an expensive one can get more expensive. It cannot remove the risk that the accounts are managed within the rules, or that a business deteriorates faster than the numbers show. And it cannot replace a decision about whether the price you are paying leaves you a margin of safety.
What it can do is give you a reason for owning a business that is separate from the price chart, and a way to notice when the reason stops being true.
Our lesson on the share market explains what a share is, and technical analysis covers the price side. Investing reality sets out what the evidence says about returns over time.
