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 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, financial strength through Piotroski’s F-Score, growth and capital allocation, standalone versus consolidated results, valuation in outline, and the warning signs that appear in the accounts before they appear in the news.

The three statements

Listed Indian companies generally publish financial results every quarter, with more comprehensive disclosures at half-yearly and annual intervals. Under Regulation 33 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, a listed entity submits quarterly and year-to-date standalone results within 45 days of the end of each quarter other than the last, and audited annual results within 60 days of the end of the financial year. The half-yearly disclosure includes a statement of assets and liabilities as at the end of the half year and a statement of cash flows for the half year. The annual report then contains the complete audited financial statements, the notes and the other statutory disclosures.

Disclosure requirements are not identical for every listed entity. Sectoral regulators, the SME platform and the specific securities listed can change what is filed and when, so read the requirements that apply to the company you are studying rather than assuming one template.

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, before dividends, distributions and other adjustments to equity.
• 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.

The three statements are interconnected through accounting entries. A change in revenue, expenses, assets or liabilities can affect more than one statement, sometimes in different reporting periods.

That interconnection is a consistency check, not a guarantee of truthful reporting. Double-entry accounting ensures that the statements balance; it does not ensure that the entries represent economic reality. A few examples show why:

• Recognising revenue before it is earned can raise both revenue and receivables.
• Capitalising an expense as an asset can raise reported profit and total assets in the same year, with the cost appearing later through depreciation or impairment.
• Depreciation and impairment depend partly on accounting policies and estimates.
• Provisions and estimates can move reported results without any cash movement.
• Aggressive assumptions can leave the accounts mathematically balanced and economically misleading.

The discipline is therefore to read the statements together, read the notes, and compare several periods, rather than to assume that a balanced balance sheet proves the numbers are conservative.

A worked example

Take a hypothetical company, XYZ Ltd, with these figures for a year, all in crore rupees.

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.

Why profit and cash differ

XYZ reports a net profit of ₹90 crore and an operating cash flow of ₹110 crore. The two are not supposed to be equal, and a simplified reconciliation shows why.

Read the lines in order:

• Depreciation is generally a non-cash charge. It reduced profit but did not take cash out of the business, so it is added back.
• An increase in receivables means the company sold goods but had not collected the cash by the year end. That consumes cash relative to reported revenue.
• An increase in inventory means cash went into stock that had not yet been sold. It also consumes cash.
• An increase in operating payables means the company had not yet paid some suppliers, which conserves cash temporarily.
• Other operating adjustments cover items such as tax paid, interest and non-operating gains, which a full statement would show separately.

Two distinctions matter. First, operating cash flow is not free cash flow. Free cash flow subtracts capital expenditure, which appears in the investing section of the cash-flow statement rather than inside operating cash flow. XYZ’s free cash flow is 110 − 40 = ₹70 crore. Second, this table is a teaching reconciliation, not a statutory cash-flow statement. An actual indirect-method statement can contain further lines for tax, interest, provisions, non-operating items and the effect of exchange-rate changes.

The useful reading is that a profitable company can generate relatively weak operating cash flow when its working capital absorbs the profit. That is not automatically a problem, but it is a question.

The ratios that matter

There are hundreds of ratios. Most are variations of a few ideas. These are the ones worth knowing first.

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.

ROCE has a definition problem that ROE does not. The numerator is usually EBIT, but “capital employed” has several accepted conventions:

• total assets minus current liabilities;
• equity plus relevant long-term debt minus cash and other non-operating assets;
• the average of either measure across the period.

The XYZ figure of ₹550 crore uses equity 450 + debt 150 − cash 50. That is a common convention, and it is closer to what many sources call return on invested capital (ROIC) than to every ROCE definition in use. A different convention would produce a different percentage from the same accounts. Whichever you use, state the numerator and the denominator, and apply them consistently when comparing companies. Where capital employed moves materially during the year, an average is usually more representative than a single closing balance.

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. Persistently weak operating cash flow relative to reported profit deserves investigation. Possible causes include growing receivables or inventory, changes in operating liabilities, tax payments, provisions, and differences between accounting recognition and actual cash collection. Some explanations are normal; others may indicate deteriorating earnings quality. One reporting period is rarely enough to judge, so compare several periods and read the notes that explain the movement.

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.

Growth is not always value creation

Revenue and profit growth are not, by themselves, evidence that a business is creating value for its shareholders. A company can grow its total profit while producing disappointing returns for the people who own it.

Read growth alongside:

• Operating cash-flow generation. Growth that consumes cash faster than it produces it has to be funded from somewhere.
• Capital expenditure. A business that needs a large new plant for every increment of revenue is a different proposition from one that grows on the same assets.
• Debt raised to finance expansion. Growth funded by borrowing transfers risk to the future.
• New equity issuance. If growth is funded by issuing shares, the total profit can rise while profit per share does not.
• Return on incremental capital. The relevant question is what return the new capital earns, not only what the existing business earns.
• Working-capital requirements. Receivables and inventory often grow with revenue and absorb cash.

The distinction to keep is between growth in the company and growth in value per share. The first is a larger business. The second is a larger claim for each existing shareholder. They are not the same, and a company can deliver the first while diluting the second.

Standalone and consolidated results

Indian companies with subsidiaries report both:

• Standalone financial statements report the financial position and performance of the reporting legal entity itself.
• Consolidated financial statements include the parent and its controlled subsidiaries, with associates and joint ventures treated under the applicable accounting standards.

Both are worth reading. Standalone results show the parent’s own business and its investments in subsidiaries. Consolidated results show the economic group, which can be materially different when valuable businesses sit inside subsidiaries. A parent whose standalone profit looks modest may own a large subsidiary whose earnings appear only in the consolidated accounts.

Neither is automatically superior for every purpose. Standalone is the right lens for the legal entity’s own obligations and dividends; consolidated is the right lens for the group’s scale and profitability. Read the one that matches the question, and check both when the group structure is material.

Piotroski F-Score: A Nine-Point Financial Strength Check

Piotroski’s F-Score is a nine-point measure of financial strength built from accounting information. It was introduced by Joseph D. Piotroski in his 2000 paper, “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers”, published in the Journal of Accounting Research.

The original setting matters. Piotroski applied the score to high book-to-market companies, the kind of cheap-looking firms where some are genuinely improving and others are deteriorating. The score was designed to separate the stronger from the weaker within that group, not to rank every company in the market.

It is a financial-strength screening framework. It is not an intrinsic-value model, not a technical indicator, and not a forecast of the share price. A high score says that several accounting signals are favourable; it says nothing about whether the current price is attractive.

The nine tests

Each test is binary: one point if the condition is met, zero if it is not.

A note on test 4, because it is the one most often simplified. In the original paper, ROA and cash flow from operations are both scaled by beginning-of-year total assets, and the accrual measure is net income less cash flow from operations, scaled the same way. The signal is one when cash flow from operations exceeds ROA, which is the same as saying the accrual component is negative. The popular shorthand “operating cash flow exceeds net income” is equivalent only when both are divided by the same asset base. If a data provider uses a different denominator, the result can differ.

Scoring and interpretation

The F-Score is the sum of the nine binary signals, so it ranges from 0 to 9.

In the original study, high scores were grouped at 8 or 9 and low scores at 0 or 1, with the middle range treated as mixed. A useful reading is:

• Higher scores: more favourable accounting signals, worth investigating further.
• Intermediate scores: a mixture of improving and deteriorating signals.
• Lower scores: fewer favourable signals, and more questions about financial strength.

Those are descriptions of the accounting evidence, not recommendations. An 8 or 9 does not mean “buy”, and a 0 or 1 does not mean “sell”. The score says nothing about price, and a strong company can be an expensive investment.

A worked example

XYZ Ltd does not publish enough of the figures the score needs, so this example uses a separate hypothetical company, ABC Ltd. All amounts are in crore rupees and the figures are constructed to be internally consistent.

The measures the score needs:

Applying the nine tests:

The score is 8 out of 9. The one failing signal is liquidity: the current ratio fell even though the company grew and became more profitable. That is exactly the kind of mixed evidence the score is meant to surface. The arithmetic here is deterministic and can be checked line by line.

Limitations

• The score uses historical accounting information, so it describes the past.
• It does not measure whether the shares are expensive or cheap.
• Accounting quality and comparability affect the result.
• Industry differences matter. Banks, NBFCs and insurers generally need different analytical treatment, and the standard nine tests are not designed for them.
• New equity issuance is not always harmful. A company may issue shares to fund a genuinely productive investment, and the test would still deduct a point.
• One year of improvement does not guarantee that improvement continues.
• Data providers sometimes modify the definitions, for example by using ending rather than beginning assets or a different accrual measure.
• A backtest of the score must use the information that was actually available on the decision date. The original study used data published after the fiscal year end, and a test that uses later restated figures can overstate the result.
• The results of the original study are historical findings from a particular market and period. They should not be read as a guaranteed return in India or in any future period.

Piotroski’s F-Score combines profitability, cash generation, financial strength and operating efficiency into a simple checklist. It is useful for identifying financial characteristics worth investigating further, but it does not replace business analysis, valuation or risk assessment. The trading strategies lesson explains how a screening rule like this becomes part of a tested strategy, and why backtest discipline matters.

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: seeking a meaningful discount to a conservatively estimated value. It provides room for estimation errors and adverse developments, but it does not guarantee against losses. A margin of safety reduces the cost of being wrong; it does not remove the possibility.

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.