Fundamental analysis

In this tutorial, you will learn:

  • The basics of fundamental analysis
  • What are financial ratios
  • How to carry out stock screening

Intro to fundamental analysis

As we have discussed in the first tutorial, fundamental analysis is a methodology for predicting the security’s intrinsic value, which may or may not be equal to its current market value. In general, fundamental analysis could be divided into quantitative and qualitative.
  • Quantitative aspect concerns about studying numerical figures like the company’s revenues, profits, assets, debts, etc
  • Qualitative aspect focuses on intangible factors like the company’s management background and brand recognition.
In addition, it is also crucial to look at economic factors like interest rates, inflation, GDP, etc. These can all affect the general situation of the company.
In this module, we’ll focus on the quantitave aspect of a company. We could get the numerical figures we need from the company’s income statements, cash flow statements and balance sheets.

Financial ratios

Instead of using the raw figures we obtained, we would use these figures to compute financial ratios that help us summarise the financial statements and the health of a company.
Here are four basic ratios that are often used to pick stocks for investment portfolios:
  • Price-earnings (P/E) ratio
  • Earnings per share (EPS) ratio
  • Debt-to-equity ratio
  • Return on equity (ROE) ratio
In the following, we’lll go through the major types of ratios and the equation for each ratio one by one.

Short-term solvency ratios

Definition

Short-term solvency ratios are used to judge the adequacy of liquid assets for meeting short-term obligations as they come due.
The higher the ratio result, the better a company’s liquidity and financial health; the lower the ratio, the more likely the company will struggle with paying debts.

Current ratio

Current ratio measures a company’s ability to pay short-term obligations or those due within one year.
\[\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}\]

Quick ratio

Quick ratio indicates a company’s capacity to pay its current liabilities without needing to sell its inventory or get additional financing.
\[\text{Quick ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}\]

Cash ratio

Cash ratio calculates a company’s ability to repay its short-term debt with cash or near-cash resources, such as easily marketable securities.
\[\text{Cash ratio} = \frac{\text{Cash equivalents} + \text{Cash}}{\text{Current liabilities}}\]

Networking capital to current liabilities

text{Networking capital to current liabilities} = frac{text{Current assets} + text{Current liabilities}}{text{Current liabilities}}


Turnover ratios

Definition

Turnover ratios represent the amount of assets or liabilities that a company replaces in relation to its sales. The concept is useful for determining the efficiency with which a business utilises its assets.

Inventory turnover ratios

Inventory turnover ratios is a ratio that measures the number of times inventory is sold or consumed in a given time period.
\[\text{Inventory turnover ratio} = \frac{\text{Cost of goods sold}}{\text{Average inventories}}\]

Receivable turnover

Receivable turnover is the number of times per year that a business collects its average accounts receivable. It evaluates the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner.
\[\text{Receivable turnover} = \frac{\text{Sales}}{\text{Accounts receivable}}\]

Fixed asset turnover

Fixed asset turnover indicates how well the business is using its fixed assets to generate sales.
\[\text{Fixed asset turnover} = \frac{\text{Net sales}}{\text{Average fixed assets}}\]

Total asset turnover

Total asset turnover measures the efficiency with which a company uses its assets to produce sales.
\[\text{Total asset turnover} = \frac{\text{Net sales}}{\text{Average total assets}}\]

Financial leverage ratios

Definition

Financial leverage ratios indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. They show how the company’s assets and business operations are financed (using debt or equity).

Total debt ratio

Total debt ratio represents the proportion of a company’s assets that are financed by debt.
\[\text{Total debt ratio} = \frac{\text{Total debts}}{\text{Total assets}}\]

Debt to equity ratio

Debt to equity ratio measures the degree to which a company is financing its operations through debt versus wholly-owned funds.
\[\text{Debt to equity ratio} = \frac{\text{Total debts}}{\text{Total equity}}\]

Equity ratio

Equity ratio represents the relative proportion of equity used to finance a company’s assets.
\[\text{Equity ratio} = \frac{\text{Shareholder's equity}}{\text{Total asset}}\]

Long-term debt ratio

Long-term debt ratio shows the proportion of a company’s assets it would have to liquidate to repay its long-term debt.
\[\text{Long-term debt ratio} = \frac{\text{Long-term liabilities}}{\text{Total equity}}\]

Times interest earned ratio

Times interest earned ratio measures a company’s ability to meet its debt obligations based on its current income.
\[\text{Times interest earned ratio} = \frac{\text{Earnings before interest and tax (EBIT)}}{\text{Total interest expense}}\]

Profitability ratios

Definition

Profitability ratios measure the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders’ equity during a specific period of time. They show how well a company utilises its assets to produce profit and value to shareholders.

Gross profit margin

Gross profit margin indicates how efficient a business is at managing its operations.
\[\text{Gross profit margin} = \frac{\text{Revenue} - \text{Cost of goods sold (COGS)}}{\text{Revenue}}\]

Net profit margin

Net profit margin indicates how much of each dollar in revenue collected by a company translates into profit.
\[\text{Net profit margin} = \frac{\text{Revenue} - \text{Cost}}{\text{Revenue}}\]

Return on assets (ROA)

Return on assets indicates how profitable a company is relative to its total assets.
\[\text{Return on assets} = \frac{\text{Net income}}{\text{Total assets}}\]

Return on equity (ROE)

Return on equity measures the profits made for each dollar from shareholders’ equity.
\[\text{Return on equity} = \frac{\text{Net income}}{\text{Shareholder's equity}}\]

Earning per share (EPS)

Earning per share indicates how much money a company makes for each share of its stock.
\[\text{Earning per share} = \frac{\text{Net income} - \text{Preferred stock dividend}}{\text{Average outstanding shares}}\]

Ratio analysis for stock screening

The ratio analysis example could be found in :code: code/fundamental-analysis/ratio-analysis.ipynb.
With the equations above, it would be easy to compute the ratios just with column manipulations:
# take equity ratio as an example
equity_ratio = df["Total stockholders\' equity"].astype(int)
               / df['Total Assets'].astype(int) # Total stockholders' equity / Total Assets

# store all the ratios in the `ratios` dataframe
ratios["Equity ratio"] = equity_ratio
After calculating these ratios, we would want to create screening masks to filter out stocks that have a relatively better performance.
# e.g. filter out stocks with profitability ratio greater than overall mean
mask1 = (ratios['EPS'] > ratios['EPS'].mean())
mask2 = (ratios['ROE'] > ratios['ROE'].mean())
mask3 = (ratios['ROA'] > ratios['ROA'].mean())
We could apply these masks on the ratios dataframe to get the filtered stocks eventually:
# apply the masks
ratios[(mask1) & (mask2) & (mask3)]

References

Attention

All investments entail inherent risk. This repository seeks to solely educate people on methodologies to build and evaluate algorithmic trading strategies. All final investment decisions are yours and as a result you could make or lose money.