Fundamental Analysis: How To Evaluate A Company's Financial Health

Investing in shares can be a great way to generate wealth. But only if you buy them from the right companies.

While in the odd rare case, lady luck might smile on you if you simply pick a name you like the sound of, you are less likely to make any money if you don’t do some proper research.

One of the most effective ways of doing this is through fundamental analysis, which involves evaluating a company’s financial health, competitive position, and overall stability before making the decision to invest in it.

In this guide, we’ll highlight the components of a fundamental analysis to help you better understand how to evaluate a company’s financial health.

What is a Fundamental Analysis?

If you are interested in buying shares in a company, such as Telstra, doing a fundamental analysis is a good idea first.

This involves assessing a company's overall intrinsic value by examining various aspects that go beyond the numbers of Telstras performance on the ASX. They include their financial statements, profitability, and growth potential, and what level of debt and liquidity they have.

It should also consider their market position, any competitive advantage they enjoy, and other macroeconomic factors that could affect their business.

Overall, fundamental analysis focuses on long-term investment potential rather than short-term market fluctuations, and the more you can understand it, the more successful your investment is likely to be.

How to Perform a Fundamental Analysis

There are several activities involved in a fundamental analysis. Here are some of the main ones you should complete before investing.

1. Read the Company's Annual Report

Another invaluable source of information about a company is its annual report, which you should read as part of your fundamental analysis. 

A good starting point is the CEO's letter to shareholders, as this provides a good overview of the company’s overall performance and, in particular, what key developments arose. 

Additionally, the report will provide you with a top management perspective of the company, although you might need to read between the lines of the letter’s tone and content.

2. Evaluate Financial Statements

For many investors, a company’s financial statements provide the most concrete data on its performance. Overall, the three key financial statements you should look at in the annual report are the balance sheet, income statement, and cash flow statement.

The balance sheet gives a snapshot of a company’s financial position at a specific time and it lists what the company owns in terms of cash, inventory, equipment, real estate (assets), what it owes in loans, accounts payable, other obligations (liabilities), and the net worth of the company as determined by assets minus liabilities (shareholder’s equity).

By contrast, an income statement shows a company’s revenue, expenses, net profits, and earnings per share over a specific period and helps investors to assess profitability. At the same time, a cash flow statement tracks the cash moving in and out of a company, which is a good way of telling if it has enough liquidity to remain a sustainable operation.

3. Read the Auditor's Report

The auditor's report within the annual report should always be read, as it provides an independent guide as to whether the financial statements equitably showcase the company's performance and financial position.

Make sure you keep an eye out for any disclaimers or qualified opinions that may suggest there are potential issues.

4. Evaluate the Management Team

Some investors believe that the management personnel in place at a company are crucial factors when it comes to investing in an organisation, and it is easy to see why.

In Premier League Football, the teams with the best players perform the best. So, it follows that the same principle should apply to companies. If a business doesn’t have an accomplished group of leaders at the helm, it won’t perform as well as it could.

It is not easy to truly control the capabilities of individuals within any given management team. But you can learn more about them by following them on LinkedIn and social media, doing online searches, and referring to the corporate section on the company’s website.

Here is our example of the Corporate Keys Executive team.

5. Assess the Company’s Competitive Advantage

Typically, a company’s prolonged success is largely determined by its ability to stay ahead of its competition.

The stronger a company's competitive advantage, the more likely it is to remain a profitable investment.

Microsoft could be one example of this because its product portfolio incorporates widely used software like Office and Windows. Additionally, it has a major presence through Azure in cloud computing, which ensures it attracts a large user base.

6. Industry Trends

Another thing to consider when performing a fundamental analysis is the industry in which the company operates.

More specifically, you should examine the industry's number of players, customer base, level of competition, and regulations.

The more you can understand the industry, the better qualified you’ll be to determine whether you should invest in a company that operates within it.