E-Marketing
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Fundamental Analysis
Fundamental Analysis probes the Balance Sheet, the Income Statement, and the Statement of Sources and Uses of Working Capital.
The Balance Sheet is a point in time view of Assets and Liabilities and Shareholders Equity (derived by subtracting liabilities from assets).
The Income Statement shows the results of operations including revenues, less the cost of goods sold, operating expenses, non cash charges, interest expenses, and taxes.
The Statement of Sources and Uses of Working Capital looks at the sources of funds and uses of funds. This statement is critical to look at how a company is sourcing its working capital requirements and capital expenditures.
Fundamental Analysis evaluates the Balance Sheet, Income Statement, and Sources and Uses of Working Capital in order to assess the following;
Liquidity
Asset Quality
Earnings Quality
Leverage
Debt Service Coverage
Profitability
Growth
Possible Problems and Opportunities for Improvement
Liquidity Ratios-
Current Ratio- ratio of Current Assets (assets maturing within one year of statement date) divided by Current Liabilities (liabilities maturing within one year of the statement date). Current Assets generally consist of Cash, Marketable Investments maturing within one year, Current Receivables, and Inventory. Current Liabilities consist of Accounts Payable, Current Debt, and Deferred Income.
Quick Ratio- ratio of Current Assets minus Inventory divided by Current Liabilities. This is a better measure of liquidity since the true nature of liquidity under duress is difficult to determine. Forced liquidations can lead to very disappointing realizations. A quick ratio over one is desirable.
Receivables Turnover- Sales for the Period divided by Average Receivables (Beginning Receivables minus Ending Inventories divided by two). The trend in this ratio is extremely important to determine credit quality of the customers and whether the company is meeting its deliverables. There are times companies will book sales even if customers have not accepted or received delivery.
Inventory Turnover- Sales for the Period divided by Average Inventory (Beginning Inventory minus Ending Inventories divided by two). The trend in this ratio is extremely important to determine whether a company is stuffing the channel or is stuck with depreciating inventory.
Comment- While it is desirable to have a Current Ratio over 2 times and Quick Ratio over 1 times, there are industries where this is not true. Utilities and truckers receive quick payments (fast turnover of receivables, little inventory) and have slow payables since they receive generous terms of trade, so that they can have ratios of 1 or less and still be completely liquid and solvent.
Long Term Assets consist principally of Property, Plant, and Equipment and Capitalized Software Development Costs. Both these items are not recorded as an expense but capitalized when put into service or as the software is completed. These long term assets are then depreciated or amortized over their expected economic life and hence recorded as an expense. Uneconomic or obsolete property or capitalized software which doesnt work or has been outflanked by competition should be written off. Companies are, at times, hesitant to startle Wall Street with these write-off and write-downs. Often, these unproductive assets build until the auditors blow the whistle and force write-offs.
Total Asset Turnover – Total Asset Turnover (Sales for the Period divided by Average Total Assets for the period) and its trend can unearth dead assets if the ratio is deteriorating and there is no valid explanation.
What to Look For!
It is important to look for the trend in these numbers. For instance, rapid sales accompanied by radical slowing in inventory and receivables turnover, may indicate channel stuffing, bad credit quality of customers or erroneous and premature booking of sales before customer acceptance. Companies anxious to hit extremely aggressive Wall Street expectations may ease credit policies, or get customers to accept too much product in return for easy credit. This robs from future quarters and suggests growth is not all its cracked up to be. This can mean a real disaster in the making. Once Wall Street Analysts are bilked, its tough to get Wall Street sponsorship back.
Companies with substantial amounts of In-Process inventory as opposed to Finished or Raw Inventory may have a lower quality of liquidity. If the economy slows, the company may get caught with substantial amounts of unsold in-process inventory, for which prices have plummeted.
Asset Quality-
In addition to turnover of receivables and inventory, one should look for capitalized expenses. Capitalization involves booking as a asset rather than an expense costs of products or assets where revenues are expected to be realized over time. In an attempt to match revenues and expenses, it is deemed appropriate to not expense software development for which there is no current revenue possibility, even if there is a demonstrable ultimate market once completed. Once the software is finished and saleable, the company will begin to amortize (expense) the capitalized cost over the time of its expected economic usefulness. Capitalization of certain expenses can lead to assets of dubious quality and liquidity where ultimate realization is subject to realistic concern.
Computer companies capitalize software development. Retailers capitalize so-called pre-opening expenses. So do restaurants. Companies capitalize software development they undertake. However, there are times when the software doesnt work and must be abandoned and written off. These assets may be of very dubious quality.
These assets may be written off, leading to so-called “one time” write-offs. Some companies engage in “one time” write-off as a normal course of business.
Channel Stuffing- Companies desperate to meet sales and earnings targets can stuff the channel by giving tremendous financing terms to their retail outlets or other sales channels like Value Added Resellers (VARS). Sunbeams and Compaqs stock prices crashed when the game couldnt be pushed anymore.
The receivables and inventory turns gave this away.