Fundamental analysis is a method of evaluating a security by analyzing its underlying financial statements and economic factors. Fundamental traders use this information to make investment decisions about whether to buy, sell, or hold a security.
One of the most important aspects of fundamental analysis is analyzing a company's financial statements. Financial statements provide a snapshot of a company's financial health, including its assets, liabilities, equity, income, and expenses.
There are three main types of financial statements:
- The balance sheet shows a company's assets, liabilities, and equity at a specific point in time.
- The income statement shows a company's revenues, expenses, and net income over a period of time.
- The cash flow statement shows a company's inflows and outflows of cash over a period of time.
Fundamental traders use financial statements to answer questions such as:
- How profitable is the company?
- How much debt does the company have?
- How liquid is the company?
- How well is the company managed?
The answers to these questions can help fundamental traders assess a company's investment potential.
In addition to analyzing financial statements, fundamental traders also consider other factors such as the company's industry, economic conditions, and competitive landscape. By taking all of these factors into account, fundamental traders can make informed investment decisions.
Here are some of the key financial ratios that fundamental traders use to analyze company financial statements:
- Price-to-earnings (P/E) ratio: This ratio compares a company's stock price to its earnings per share. A high P/E ratio indicates that investors are willing to pay a premium for the company's stock, perhaps because they believe the company has strong growth potential.
- Earnings yield: This ratio is the inverse of the P/E ratio. It measures the amount of money a company earns for each dollar invested in its stock. A high earnings yield indicates that the company is undervalued.
- Debt-to-equity ratio: This ratio compares a company's total debt to its total equity. A high debt-to-equity ratio indicates that the company is using a lot of debt to finance its operations. This can be a risk factor for investors, as it means the company is more likely to default on its debt payments.
- Current ratio: This ratio measures a company's ability to meet its short-term financial obligations. A current ratio of 2 or more is considered to be healthy.
- Quick ratio: This ratio is similar to the current ratio, but it excludes inventory from the calculation. This makes it a more conservative measure of a company's liquidity.
These are just a few of the many financial ratios that fundamental traders use to analyze company financial statements. By understanding these ratios, fundamental traders can gain a better understanding of a company's financial health and make more informed investment decisions.