INVESTMENT ANALYSIS

&
PORTFOLIO MANAGEMENT

Lecture # 19
Dr.Shahid A. Zia 1
 Why Balance Sheet Is Important?
• 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? 2
 Items in Balance Sheet
Assets
Current Assets:
Current assets are assets that are usually
converted to cash within one year.
– Cash 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.

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 Items in Balance Sheet
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 short-term government securities and
money market funds.

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 Items in Balance Sheet
– Accounts receivable represent money
customers 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.
– 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. 5
 Items in Balance Sheet
Assets
• Long-Term Assets:
– Long-term assets are grouped into several
categories. The following are some of the
common terms may be encounter:

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 Items in Balance Sheet
– 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.
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 Items in Balance Sheet
– 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.

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 Items in Balance Sheet
Liabilities:
Current 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.

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 Items in Balance Sheet
– 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.

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 Items in Balance Sheet
• Long-term debt:
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.

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 Items in Balance Sheet
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.

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 Balance Sheet Analysis
• 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.

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 Understanding the Income
Statement
• 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.

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 Understanding the Income
Statement
• If a company continues to record losses for a
sustained period, it could go bankrupt.
• On the other hand, a company that realizes
large profits will have more money to pass on to
its investors.

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 Items in Income Statement
Net Sales:
• 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.
Cost of Goods Sold:
• 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.
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 Items in Income Statement
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.
Gross Profit on Sales = Net Sales - Cost of Goods
Sold
• Gross profit on sales is important because it
reveals the profitability of a company's core
business.

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 Items in Income Statement
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.
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 Items in Income Statement
Depreciation:
• Depreciation is the gradual loss in value of
equipment and other tangible assets over the
course of its useful life.
Earnings Before Interest and Taxes:
• Earnings before interest and taxes (EBIT) is the
sum of operating and non-operating income.
EBIT = Operating Income +(-) Other Income (Loss) +(-)
Extraordinary Income (Loss)

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 Items in Income Statement
Other Income:
• 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.

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 Items in Income Statement
Extraordinary Income (or loss):
• 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.

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 Items in Income Statement
Interest Expenses:
• Interest expense refers to the amount of interest
a company has paid to its debtors in the current
year.
Net Earnings (or Loss):
• Net earnings or net income measures the
amount of profit a company makes after all of its
income and all of its expenses. It also represents
the total amount that may be distributed to its
shareholders.

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 Items in Income Statement
Dividend:
• 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.

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 Items in Income Statement
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.
Retained Earnings = Net Earnings - Dividends

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 The Importance of the Income
Statement
• 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.

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 The Importance of the Income
Statement
• 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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 Cash Flow Statement
Relationship between CFS and
Balance Sheet
• CFS explains the change in the cash and
the cash equivalents in detail it reconciles
the opening and the closing balances of
cash and cash equivalents.

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 Analysis of Cash Flow Statement
• A statement of CFS assist investors, creditors,
shareholders and other users of financial
statement to analyze the following;
• The companies ability to generate the positive
cash flows.
• The companies ability to meet its obligations.
• The companies need for external finances.

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 Analysis of Cash Flow Statement
• CFS in conjunction with the balance sheet
provides information on liquidity, viability and
financial adaptability of company.
• It gives indication of relationship between
profitability and cash generating ability.

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 Managing Cash Flows
Management’s basic responsibility is to insure
that the company has enough cash to meet its
obligations.
• Management prepares cash budget and
forecasts future cash flows.
• It helps the management to plan in advance by
providing them the resources at their disposal
and the results they are expected to achieve.

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 Managing Cash Flows
• Future is unobservable.
• Factors.
• Opportunity & Threats.
• Strengths & Weaknesses.
• Income & Expenses.
• Reserves.

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 Cash Management
• Provides target in evaluating departmental
performance and warnings of potential cash
shortages.
• Budgeting of Future cash flows is an important
tool while evaluating the viability of a new
investment / project.
• It also helps in identifying the time and amount
of funds needed.
• Positive inflows.
• Negative outflows.

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 Discounted Cash Flows
• Future cash flows give pay back period of the
investment made.
• Return on average investment (ROI) is the
annual net income from an average investment
expressed as a percentage of average amount
invested.

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 Discounted Cash Flows
• The present value of an investments future cash
flows is the maximum amount that investor
should be willing to pay for the investment.
• An investment is considered desirable when
cost is less then the present value of the future
cash flows.
• The higher the required rate of return for a
particular investment the less investor would be
willing to pay for the investment.

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 Discounted cash flows
• Inflation.
• Time.
• Time Management.
Following is required to arrive at the present
value figure;
• The amount of future cash flows.
• Length of time, an investor must wait to receive
the cash flow.
• The discount rate.
• Discount rate are always changed.
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Financial Analysis

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 Fundamental Analysis
• Ratios.
• Liquidity.
• Balance Sheet.
• Items in Balance Sheet.
• Income Statement.
• Statement of cash flows.

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 GATHERING INFORMATION
Research Philosophy
• Know Thyself.
• Screening.
• A research philosophy is helpful in making the
best use of research time.
• Many analysts use a combination of
fundamental, technical, and wise man
techniques.

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 GATHERING INFORMATION
Research Philosophy
• Regardless of the approach taken, analysts /
investors need to decide upon what type of
information they want to gather and to be clear
why this information should be useful.
• Screening is necessary in order to reduce the
huge number of possible investments to a
smaller number that can investigated carefully.

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 Resources at the Library
• Economic financial Newspapers.
• Standard & Poor’s Publications.
• Mergent / Moody’s Publications.
• They are competitors and their services largely
duplicate each other.

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Websites

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 Resources at the Library
Company Information:
• Annual Reports.
• SEC Filings.
• The Prospectus.
• Objective.

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 The Stock Exchanges
The Karachi Stock Exchange.
• www.kse.com.pk
Lahore Stock Exchange.
• www.lahorestock.com
Islamabad Stock Exchange.
• www.ise.com.pk

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 Computer/Internet Services
Screening Services

• Brokerage Firms.
• Investment Seminars.
• Bank Trust Departments.
• Employee Relation Programs.
• Exchange Seminar.

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 INVESTMENT LETTERS
Advisory Letters
The Popular Press
OTHERS:
• Earnings forecasts are the meat of the
I/B/E/S and Zack’s services.
• A great many other sources of information
are available through magazines,
newspapers, or television shows.

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