Todays Presentation Is Fundamental Analysis

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02 Nov 2017

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The topic of our today’s presentation is Fundamental Analysis.

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In this presentation we will start by looking at what is Fundamental Analysis and study various aspects of fundamental analysis. We will see how the Top down approach works and what is the level of analysis needed at each level. We will also see how various factors like interest rate, demand and supply and government policy can affect the macro economy and last but not the least we will also see a very important part of Fundamental Analysis i.e., the Ratio analysis, where we will also calculate certain ratios.

Now let us start with our presentation. Lets see a small disclaimer for this particular presentation.

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It is a disclaimer which basically says that whatever we tell you here is only for educational purposes, we don’t provide you here with any kind of investment advise.

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Fundamental analysis is a security analysis method by which a person can analyze financial products such as shares or stocks which uses financial and economic analysis to find probable future outcome or movement of stock prices.

The fundamental data that is analyzed may include a company’s financial reports and also non-financial information like estimates of its growth, demand for products sold by the company, comparison with different industries, any changes which are affect major economies or world economy etc., and also changes in government policies and many other things.

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Some people believe that Fundamental analysis is the cornerstone of investing and in fact most types of investing involves studying at least some fundamentals, one of the most important part of fundamental analysis done on share involves analyzing into the financial statements where an analyst looks at

ï‚§ revenue,

ï‚§ expenses,

ï‚§ assets,

ï‚§ liabilities and all the

ï‚§ other financial aspects of a company.

to gain an insight into a company’s future performance that might help in taking investment decisions.

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The main steps involved in Fundamental analysis are Macroeconomic analysis, Industry analysis, Financial analysis of the company and then valuation.

Where Macroeconomic Analysis involves analysing capital flows, interest rate cycles, currencies, commodities, indices etc.

And Industry analysis involves analyzing the industry as a whole and the companies that are a part of the sector, after which analyst may analyze the company and valuation.

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Fundamental Analysis begins with analysing the Fundamentals.

Fundamentals means the ability of an asset to generate income or in other words, to generate profit or returns.

Hence, the word ‘fundamental’ here is associated with the income from financial products like, for eexample : Stock, real estate , Bond currency etc.

Fundamentals generally means the ability of an asset to hold its value and also generates income.

Now, based on fundamentals, The next important concept is of valuation which means the ability to use investment analysis to assign values to an asset. In this particular case , Fundamental analysis is used to assign a value to an assets like commodities for example, gold, crude oil, potato, rice etc. and currencies. The valuation is the process which mostly uses income information such as fundamental analysis to assign these values.

The next important concept is analyzing the asset using Top down approach which is covered in the next few slides.

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There are two approaches to Fundamental Analysis :

1. Top Down Approach

2. Bottom up approach

In the Top Down Approach, an analyst first studies the Global Economy then the Macro economy then Industry Analysis, lastly the company is analyzed while in the Bottom up approach is just the opposite starting from the bottom i.e., first the company then industry, then Macro economy and finally the Global economy.

Generally, Top Down approach is preferred by analysts because it is believed that if you go wrong with the Macroeconomic level or industry level, there is very less chance of making any returns. Therefore, like many other analyst we will also follow the Top Down approach in following slides.

In the Top Down approach which begins with analysing the Global economy and the overall potential of a particular country or a particular (financial) asset with respect to the global environment. In the next step we analyse the Macro economy because in a recessionary environment if the macro-economic fundamentals are strong, the recession will generally be quick and economy will generally be able to recover faster.

The third step where the industry is analysed. In a recessionary environment it is probably better to invest in education, Food & energy and similar industries, these industries are generally called as defensive industries. A defensive industry is the industry which is generally not affected much when overall economy is badly affected because no matter how bad the economy, people will not cut down on essential items like food and water etc. essential for their survival while they may cut down on going to expensive restaurants, buying expensive food items etc. The opposite of defensive industry is the cyclical industry which generally suffers significantly during economic crisis & generally prospers well during the economic recovery for example luxury products/services industries like expensive car, jewellery etc. And last step is to look at the company itself in that industry under consideration, here the analyst should look at if the company is profitable but should not be overvalued.

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Studying Macro Economy relates to studying 3 major factors i.e., Economic Growth, Business Cycles, Macro Investing.

Healthy growth depends on a number of factors like 1. good savings, 2.Sound investments, on production &productivity resulting from investments and economic liberty or relatively small regulatory environment.

Business cycles are important to see when the economic cycle is weakening and recovering before others. if recovery is timed wrongly it will result into huge losses, therefore it s very important to get the business cycle right.

Micro Investing

It is more important to find the right economy to invest in then the right company to invest in.

So, you have to figure out the boom right, and then the industry and then company and lastly find out the right entry point to buy when it is not overvalued (here studying market history will help a lot). Because if a company is good but is highly overvalued, it may take many years to even recover the original investment amount.

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Economic Growth :Economic Growth is necessary to determine whether the economy will have strong or weak growth, strong or a weak recovery or shallow or deep recession. One has to study here the business cycle.

Inflation : It is very important to analyse the investment with respect to the inflation else it would lead to an illusion that it is a good return on investment if you are doubling you money in 9 or 10 years but what is not realised is that the purchasing power of their money has decreased substantially and the real return is zero or negative.

Inflation is extremely important because it helps in knowing the real return on investment.

Also, if we study various types of investment with respect to the inflation rate then we might some investments really attractive while some others which we thought are giving good return (Nominal) but are actually bad investment as they offers very low or even negative real return. Lets see now see some examples of this phenomenon :

Our first example would be of -

Bonds: if you get nominal Returns on bonds, and inflation is high and rising, bonds will become extremely risky investments and will most probably get lower or negative real returns.

Next, let us now consider another example, say -

Stocks: if it is a very high accelerating inflation scenario, it is risky for stocks too and becomes important for commodities to outperform and Real estate will generally flow with inflation unless you have bubbled or had severe recession so not as important for real estate.

Next concept we are going to talk about is -

Unemployment: In general, when people do not have jobs they tend to consume less and If consumer are confident about the economic scenario they tend to spend more. This spending translates into company revenue which further decides if company has earned profit or loss and eventually that translates into higher/lower stock value. In general, When unemployment rises, it affects the consumer spending capability, hurting businesses where when some of them which can not bear any more loss may get bankrupt and even close.

Productivity : Productivity is another important factor which primarily denotes the health of the economy is measured. Rising or high productivity symbolises strong fundamental health of the economy and results into higher profitability for the company and vice versa.

Fiscal Policy : Fiscal policy generally is concerned with two important factors i.e, Government taxes and Government spending.

In general when taxes are raised either on people or the businesses or on both, it hurts the economy as it hurts their incentives, and in general raising tax is considered overall bad for the economy. Governmental spending is one of the most controversial topic as Keynesian school of thought says that government spending can boost the economy, older classical school in general considers it to hurt the economy. A better way to understand it can be that in general Government spending provides a short term relief to the economy but in the long run it can only hurt the economy. And this Short term relief comes at much higher cost of tomorrow.

Trade deficits: A healthy economy runs between trade surpluses i.e., where exports are more than imports, while an unhealthy economy has imports more than exports. When a country runs a trade deficits when can interpret that it may be not producing? When a country is not producing or producing less than required it has to import products in order to fulfil the consumptions needs. Therefore, Trade deficits is a resultant of lower or negative savings.

When a country is running trade deficit it means it is not saving enough and importing capital or savings from abroad. Trade deficits are said to be equal to the capital surplus as capital surplus is used to pay for the trade deficits for example in the case of vendor financing. For example, when goods are produces in China, it sells to the rest of the world like to U.S., U.K., India etc. and also provides the credit for selling it.

Low savings : savings are necessary when a country has low savings the interpretation of low savings is that, low savings results in low investments, which result in low productivity. Now you can see that why china’s trade surpluses are indicative of strong economic health. First, they are actually producing, they do having high savings, and also high investments and high productivity and be it any economic scenario - whether there is a crisis, depression or bust they will continue to have the machine , the equipment, the productivity, the labour skill etc., which is necessary for them to produce and make profit.

Growth : In general relates to GDP.

Sentiment is what people feel, whether it is good or bad. Here we are concerned about sentiments of consumer and producers. If the consumers feel good, strong and positive in general they will consume more and businesses will boom when producers good or strong or positive they want to invest more in expectation of higher sales. The growth of the economy relates to GDP where consumer sentiments affect the consumption and producer sentiments affect the investments part of the GDP.

Interest Rates: While considering investments it is very important to know if the interest rates will be rising or falling in the future as it affects your investment directly as interest rates directly determine interest on bonds, for stocks they affect the discounts on stocks. Rising interest rates is usually considered bad for the stocks because it results in rising discounts factor. It is quite important to be sure if you are considering real or nominal interest rates. We will be discussing interest rates further in our next slide.

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Interest Rates: Interest Rates affect the overall returns on investment as High interest in general means getting high return on your bonds as corporation then may have to pay high interest rates to their borrowers, this means interest rates generally mean a cost or an expense for businesses, this would mean that high interest rates result into hurting corporate profits.

The two types of interest rates are risk free interest rate and corporate interest rate.

Risk Free Interest rates: This is the interest rate is the interest rate which is paid on government bonds that are considered default free even these are not completely risk free and are subject to the risk of inflation. These are considered default free because it is a general notion that the Government will likely not default as it has the option to print the money and pay back the loan.

Corporates Interest rates: This is the interest rate that is paid on corporates bonds. One category of corporate bonds is Investment Grade bond which is considered to be a high quality bond or in financial terms a relatively low risk. Opposite to investment grade are relatively higher risk Junk Bonds.

Risk premium is the percentage interest rate which is paid by the borrower to induce the investor to take higher risk.

Let us now look at how these interest rates affect different asset classes.

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Now as we know what is an interest rate?, let study how interest rates affect different asset classes?

A.Stocks : if the interest rates are rising they affects stocks directly in two different ways:-

Number 1. The Cost of borrowing: rising interest rates would lead to a rising cost of borrowing which will further decrease corporate profits resulting into lower return on assets and lower return on equity. In other words, Companies will be making less money because they will be paying more on interest, so that means less money or return for the shareholders and which is negative for stocks. The another reason is Discount rate or factor.

Discount Factor : which is the percentage of the required rate of return which is used in the discounted cash flow formula to compute the present value of earning or dividends. The present value formula is :

PV = DIV1 +DIV2 + DIV3 + ……+ DIVn

(1+RRR)1 ((1+RRR)2 (1+RRR)3 (1+RRR)n

Where, PV = Present Value

DIV = Dividend

RRR = Required rate of return

The interest rates here, determines the Required Rate of return so if RRR, which is in the denominator term in the above formula, goes up, the present value necessarily will go down or in other words, rising interest rates result in a higher discounting factor and higher discounting factor results in a lower present value, so again the stock gets hurt.

So we can conclude that rising interest rates are bad for stocks because they reflect high cost of borrowing and raise the discount factor on the future dividend/earnings but they are considered good also as they are considered as representing a stronger Macro economic growth which is considered as stronger demand and stronger borrowing.

The formula for the required rate of return would be :

RRR = RFR(Interest rate) + Equity premium

Where, RRR is the Required Rate of Return,

RFR is the Risk Free Rate of return (interest rate) which is the same interest rates that we discussed here and

risk premium is the premium that a investor requires to undertake the risk over and above the risk he might take in risk free investments. Risk premium can be for bonds like corporate bonds and is known as risk premium for bonds, and risk premium for stocks is often called Equity premium.

B. Bonds

Rising interest rates are bad for bonds while falling interest rates are good for bonds. Rising interest rate are good for bonds as the yield on existing bonds goes down for example, if there is a bond which is yielding 3% and then the interest rate rises to 5%, the yield on this existing bond will decrease.

C. Currency

Rising real interest rates are good for the currency i.e., they strengthen the currency. Currency yielding 1 % of interest is considered relatively week and currency yielding 10% of interest is considered relatively strong. At 1% is weak because probably the government is printing a lot of money to maintain it artificially low and at 10% probably the government is not printing. So, at rising and/or higher interest rates its likely that the money supply is actually shrinking which will strengthen the currency. So we can say that, low real interest rates can weaken the economy and high interest rates can strengthen the economy.

It is a negative relationship as higher inflation will reflect the weakening of the economy and the deflationary currency. So we can conclude that, high interest will usually result in an appreciating currency and low interest rates usually result in a depreciating currency.

Rising real interest rates will hurt commodities and falling interest rates usually help commodities. If government pays you 1% ,and inflation is higher than that, then investment into bonds will result into negative return, it will be better to invest into commodities like Gold , Silver, Crude oil etc. Why?

D. Commodities

Rising real interest rates will hurt commodities and falling interest rates usually help commodities. If government pays you 1% ,and inflation is higher than that, then investment into bonds will result into negative return, it will be better to invest into commodities like Gold , Silver, Crude oil etc. Why?

Because, price of commodities like Gold are said to move in direction of inflation that is why?, In times of high inflation, commodities like gold is the choice of investment as its value of the gold can remain relatively stable for many years.

To summarize, we can say that, generally rising interest rates hurt Stocks, Bonds, and commodities but strengthen the currency.

We just saw how interest rate can affect different asset classes, but it is possible that a decrease in interest rate may not have any effect on borrowings, Our next slide will look at the situation known as Liquidity Trap.

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Liquidity Trap, generally is a condition in the economy where even the lower interest rates are not able to induce borrowers, specially, private borrowers, to borrow more money, affecting their ability to spend or invest more. For example, even when the Central banks reduces interest rates to zero people are still are not borrowing, this is known as a situation of classic liquidity trap. So, the only thing the government might do is borrow and spend itself so that it can stimulate the borrowing in the economy, government might do this because it feels that it has to keep the credit flowing in the economy otherwise the credit system might freezes which may lead to freezing of the whole economy as it is based on Debt and debt is the driver of the economy if debt stops economy might freeze.

So, the central bank acts as the lender of the last resort but government is now acting as a borrower of last resort. It might work like this that the central bank is the only one that lends money and the government is the only one that borrows money and spends, to keep the economy going a little longer.

So, The fundamentals of the interest rates are the determined by the supply and demand of loanable funds. Short run interest rates are not determined by the liquidity effect rather liquidity effect is captured in the supply of loanable funds through the Central Bank. Since we have studied now about demand and supply, let us look at some shocks to this demand and supply.

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Demand and Supply shocks

While doing macroeconomic analysis it becomes very important to understand Demand and Supply shocks and their effect. Lets see the Demand shock first.

Demand Shock

The demand shock can be simply described as an shock or change in the economy having significant effects on overall demand of the economy. For example, When there was a news about a diseases outbreak like Swine flu in Mexico or Bird Flu in India, no one would like to go to that country and hence there might be no or very less demand or a shock to the demand side, also known as the Demand shock.

Supply Shock

Similarly, Supply shock is a shock or change which can affect supply positively or negatively. For example, Hurricane Katrina or Tsunami in Japan or recent Hurricane Sandy in U.S. (which affect New York and New Jersey area severely) which blocked or even destroyed the ways of transportation like bridges and roads have affect the supply badly at that time. Another example, can be pests on crops which can destroy supply, these both are negative shocks to supply but there can be positive shocks also for example, there is a lot of good crop that year or because of a good price for a particular crop, lot of farmer produce that same crop and now there is over supply.

INDUSTRY EFFECT

In the Industry Effect only one industry is affected like say, the in case of meat(poultry) industry but it may have secondary effects, for example in case of bird flu, it killed a lot of birds, the food industry suffered as well as the restaurant industry also suffered. So there are repercussions on other industries as well, so it is important to analyse about all such effects leading to a Demand Shock or Supply shock to all the industries that might be likely affected by that demand or supply shock.

While doing Fundamental Analysis, we need to understand how a particular industry is affected by different demand and supply shocks. An industry can also affected by changes in Government policies, lets us look at how different government policies may affect an industry in the next slide.

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The government policy or changes in government policy may affect both demand and supply. The policy which affects the demand is known as the demand – side policy and the policy which affect the supply in a particular industry is called the supply side policy. Lets us look them in detail.

Demand – side policy : It is a Government policy which affects/will affect the demand for a some specific goods and hence affects only those industries related to those goods. For example, a government of a country says that everyone who has one child will get say, upto 20% rebate in taxes payable and on second child another 10% but no rebate after that then there might be an increase in number of babies resulting into increase in demand for whole lot of products from baby food to toys to diapers to furniture etc., and as they grow up a need for school, books, cycles, etc., and as they grow up a demand for colleges , cars etc. hence it is affecting demand for whole lot of goods and services in an economy.

Supply – side policy : : It is a Government policy which affects/will affect the supply for a some specific goods and hence affects only those industries related to those goods. Lets look into this in some detail:

Number 1 –

Infrastructure

Infrastructure is very important for overall growth & prosperity of an industry and also the country. Lets say Government focuses on improving infrastructure of a particular state like Gujarat, in India, and builds high quality roads, telecommunications, Internet, Cable services, Electricity etc., more and more companies would like to open their offices there, since more offices will be open , more people who work in that place would like to live nearby and a need for houses and shops and furniture etc. hence an overall development of that area.

Next

Taxes -

For example, Government wants to restrict smoking of cigarettes and says to companies producing it that anyone producing more than a certain level of cigarettes in a year will have to pay 90% of revenue in taxes. Then the producer firm which will produce more than that level would not only have to pay 90% of revenue in taxes plus has to pay for labour and other charges wherein its income may become negative and hence no incentive to produce more. Hence every company in cigarettes industry will now like to stay in quotas/limit decided by the government.

Both demand side policy and supply side policy are short term policy, they work still they stop working anymore.

Second type of classification of the policy is based on how it is implemented by the Government it? The two policies which come under this type of classification are Fiscal policy and Monetary policy which each can affect Demand or Supply. Lets look at this in our next slide.

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FISCAL POLICY:

Fiscal Policy generally means the uses of Government taxes and Government spending to affect the overall economy or maybe, specific industries in the economy which might have the long term effect on the economy.

To understand it better, lets take example, when people spend on infrastructure they generally affect economy mostly in the long run while giving donation (in money) for buying clothes or food, generally affects economy in the Short run. Government spending is a part of aggregate demand.

There is a term called "FINE-TUNING the economy" which generally means that in case, a particular product has a little less demand, the government can spend some more because the government spending is effectively a demand for the economy, the government can therefore adjust for higher demand or lack of demand by cutting own its own demand or increasing its spending to keep up the overall aggregate demand of the economy.

Supposedly, if the aggregate demand falls the resultant might be that the aggregate supply falls which means that the overall economic output or growth will fall.

While the Fiscal policy is about government spending and government taxes monetary policy is about printing money. Lets look at it in detail.

MONETARY POLICY:

Monetary policy is controlling the money supply which is the quantity of money in circulation that affects demand or aggregate demand. Let us nor look at some tools that government can implement from time to tme in order to control the money supply.

Interest rates :

One of the tools of the monetary policy can be interest rates which government can affect, that is usually short term interest rates through use of different tools. Rather than being a tool interest rates can also be a target, say it can targeted at 1%.

OMO (Open Market Operations):

An open market operations can be simply described as a buying or selling of assets by the Central Banks in order to affect the money supply. Usually OMO are done through short time government treasuries for example one to three months treasury bills affecting say, the 3 month interest rates.

Discount loan:

If commercial bank is in trouble, the central bank of that country may offer it a discount loan but the quantity of loan demanded by commercial bank/s will depend on rate of discount offered by the central bank, if the rate is on the higher side fewer banks may borrow and vice versa. The rate at which commercial banks borrow from the central bank here, is known as discount rate.

Reserve requirements:

In most countries these days, Central banks impose minimum reserve requirements on commercial banks, where in the commercial bank do not have to keep 100% of reserve but only fraction of it say, 25% or 30%. Reserve can comprise of cash or gold etc., which on demand can pay of a liability like demand deposit, fixed deposit etc. The ratio of reserves to the liabilities is also called as reserved ratio, which the central bank decides and commercial banks have to maintain. At any point of time the central bank of the country may increase or decrease the reserve ratio.

A central bank can lower reserves and increase money supply in an economy by using either or more of the above tools like Interest rates or Open Market operations or Discount loans or reserve requirements, lowering reserve requirements is expansionary in nature and hence is also known as expansionary monetary policy would result into higher aggregate demand and the opposite is true for contractionary monetary policy.

QUANTITATIVE EASING

Quantitative easing is the process where Central bank buys assets with the freshly printed money hence increasing the monetary base. Generally, this is not a good option and used in really bad conditions as it increases problems for future, as the same number of assets are chased by more money.

The third type of classification would be Regulatory, lets see it in the next slide.

Regulatory :

When a government uses its power to affect the economic outcome and get desired result, in order to regulate the economy for example, in a country like India, Government says everyone who want a driver’s licence from now on would have to complete a 15 days training in a driving school and also has to pass a written test before giving the actual driving test. The demand for driving school most probably would suddenly increase.

The next question is how does the government uses these policies? Well, if a government needs a fast response, fiscal policy is the fastest, it can give result in say, even a month while monetary policy can take from 6 months to even more that 2 years, and would affect the overall economy but the regulatory policy only focusses on affecting a particular industry.

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The overall economy moves in cycles up (i.e., boom or expansion) and down (i.e., bust or recession or contraction etc.)

Periodic : this happens in periodic or regular basis but not necessarily for the length of time (or also known as the phase) for example the economy can go up for 7 years but then goes down only for a year.

The highest point in the boom is called the peak and the lowest point in the bust is called a trough.

Let us look at the business cycle in detail in the next slide.

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These Business cycles involve so called Macro economic risk.

Macro economic risk : is the risk associated which affects the whole economy and generally cannot be diversified like Market risks.

Market risk : This is a risk associated with a particular company or industry and hence can be diversified, diversification here means "not putting all your eggs in one basket" i.e., not put all your money in one company or product risking all the money in your portfolio. For example, if you diversify, in say 2-3 industry which give you complete diversification , now if one goes down other might rise offering a hedge against the value of portfolio going down. Since you can take care of company risk through diversification, lets us look at type of industries which perform well and not very well depending on Macro economic conditions of the economy.

Our first type of industry is :

Cyclical Industry: the cyclical industry or stock is an industry or stock which perform well during the economic boom while badly during the bust. For example – luxury items like Jewellery, expensive painting, expensive cars, real estate etc. perform quite well when the overall economy is booming and people have a lot of cash in hand but do badly when economy is in recession. Our next type of industry is,

Defensive Industry : the defensive industry or stock is an industry or stock which is not affected much by a downturn in the economy. For example – necessity items like Medicine, Food , etc. People may cut down on expensive restaurants and food joints but would not stop eating, similarly when sick people will take medicine if they get sick.

Moving from one type of industry to another is called rotation but how should one know what state the economy is in and when the next state is coming? This can be done with the help of indicators, which is our next section.

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There are three types of indicators, that are -

Leading : As the name suggests, this is an indicator which precedes or leads the business cycle i.e., it tends to change before the wider economy changes or peaks before the business cycle peaks and bottoms before the business cycle bottoms

Coincident: This is an indicator which peaks when the business cycle peaks and bottoms when it bottoms.

Lagging : As the name suggests, this is an indicator which succeeds the business cycle i.e., it tends to peak after the economy peaks and bottoms after the economy bottoms.

These indicators are not perfect but are most likely to pint into the right direction.

How should they be used?

Use the leading indicators to find the future trend in business cycle and coincident and lagging indicators to confirm that trend. Lets see some examples of each of them in the next few slides.

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Some of the leading indicators can be :

Stock Market : Stock Market is said to lead the economy.

Initial Unemployment claims : It is when a person has lost his job and goes to ask for unemployment benefits for the first time after he has lost his job. If it is seen rising , that means more and more people are losing job and if it is decreasing less people are losing their jobs which might suggest that the economy might be on the path of recovery

Industrial Production or New Orders or Weekly hours of production : if any of theses is increasing it means that the businesses have confidence that they will be able to sell more in the future and hence are increasing their production, which might suggest that the economy might be on the path of recovery and if the opposite is true and these number are decreasing then economy might be on path of recession.

Building Consents or Housing starts: Building consents is a permission given to make a new buildings in the future indicating that the economy may be on the path of recovery as their will be demand for labour, raw material required, a demand furniture and electronic items like TV, washing machines etc., in the future. Housing Starts indicates that the real economic activity has started as the number shows new residential buildings that began construction during the previous month hence indicates.

Consumer Confidence: it is a indicator of consumer spending as it accounts for a majority of overall economic activity in an economy. If consumer are feeling positive about the economy they will generally tend to spend more and otherwise, if they are not.

Leading indicator : this is a composite index based on some of the leading economic indicators which might suggests where the economy is headed.

One indicator might be misleading so it is always better to look at more indicators to know the possible trend of the economy.

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The examples of coincident indicators can be :

Non farm employment : it is an indicator of estimated changes in the number of employed people not including the agricultural industry and government during the last period or month, hence is likely to tell the real situation of employment in the economy.

Personal income : it is an indicator of the income received by the consumer from all sources, the more is the disposable income, the more likely are the consumers to increase their spending.

The examples of lagging indicators can be :

Unemployment : it is an indicator of people in work force that are still unemployed for example during the past month

corporate profits : it is an indicator of profits earned by the corporates in the past period

Realized sales : it is an indicator of total value of sales that has happened at the retail level

New Home Sales : it is an indicator of new single-family homes that were sold during the past month and lastly the

Interest rates are all good examples of lagging indicators

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The next step Top – down approach is Industry Analysis.

Important industry that can be analysed can be Mining, energy, water, Food etc. While doing industry analysis one may find that :

1.Forecasting is very difficult and it is not only important to get it right but to get it better than the others.

2. Industry performance varies across the Business cycle.

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A Business cycle can affect the industry in these possible ways:

1.Sales : Sales is a very important figure of any company, if business cycle takes a downturn Cyclical industries like luxury items sales falls a lot while for defensive industries which are necessities items, sales is more or less inelastic and hence falls less.

2. Operating Leverage: which measures the flexibility of the cost structure. Total cost has basically two components Fixed cost and variable cost, if the fixed costs component is very high the cost structure of that firm will be more inflexible, than the one which has less fixed costs as one can easily vary the variable cost structure with the output required specially in bad times when business cycle is in the bust. The operating leverage is very high in industries like car manufacturing business, construction etc., and less in industries like services for example home tuition, maid, call centre. etc.

3. Financial Leverage: which measure the vulnerability of the financial structure which has generally two main components i.e., debt and equity, more the debt in the financing of the corporation the more is the vulnerability.

These 3 components determine the Profit sensitivity i.e., also known as beta, to the industry in consideration. So, how can one use business cycle trend to his benefit, our next slide is about that.

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Sector rotation is the process of moving out of some industries which might underperform due to the business cycles and at the same time moving into industries which might outperform in the future due to the business cycle in order to maximize the return. In order to do this one has to also know that life cycle stage of the industries in consideration.

There are four major stages of Industry life cycle i.e., early stage, growth, maturity & the decline stage. For Example : Fuel efficient vehicles and vehicles which use gas (CNG and LPG) or electricity are in early stages while communication that involves internet & computer are at maturity while mobile which have internet connectivity that can send messages for free like watsapp, are in early stages)

Once the right industry is found then next step in the Top down approach is to find the right company, or the company which has sound fundamentals and can give us the maximum return, within that industry. In the Next few slides we will look into how to evaluate company stock or equity in detail.

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One way to find the best company to invest in within a particular industry is by comparing its share price (price per share ) with these values, i.e.,:

1.Book value : book value per share, but since book value is subject to depreciation, different people and company might follow different methods of depreciation (LIFO, FIFO, etc), hence is sometimes difficult to evaluate and compare

2.Liquidation value : it is the value of company if all its assets are sold and its liabilities paid off.

3.Replacement Cost : it is the money you need to spend if you want to rebuild the company as it is today for example if we take an example of factory the every thing from buying the Land to build a building to put furniture in it etc., at present day prices.

If you divide each of these by the number of outstanding share and compare with the Market Price of the share, and if you find Market price is below then say, the book value then may be the company is undervalued and overvalued otherwise. Similarly for the other two values. But these comparisons should not be used alone, an analyst must look for some more information before taking a decision. For example, if the stock of a company does look undervalued but will offer very little return, is it still a good investment ? May be no. So lets us look at this in detail in the next slide.

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1. Expected Holding period return or HPR : it is the total return on the investment irrespective of how long it is kept. Since in Holding period return time is not a factor, therefor a 3% return on investment can be very good for say, a day but bad for a year. Therefore, we will look at another concept i.e., Expected Return and Required return.

2. Expected Return : It is the annualized return on any investment

Required Return : it is the return required by an individual in order to take the risk involved in investing say, in a particular stock.

Now, if Expected Return > Required Return, the stock is Undervalued else if Expected Return < Required Return , the stock is Overvalued.

3. Market Capitalization rate or the Yield to Maturity is the expected rate of return on investment if it is held until the maturity date, like bonds. The yield to maturity is sum of all the income aspects of your investment like for bond it is a sum of all the coupon payments as well as the capital gain.

Now as we know a lot evaluating a company, in the next part of our presentation we will look at how to do company analysis with the help two case studies, where we will talk a lot about key concepts like important part of a financial statement and ratio analysis.

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Company Analysis

One way to analyse a company fundamentally is to understand its financial statements and do Ratio analysis, in the next few slides we will try to understand them better with the help of two case studies.

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There are basically two types of industries : Defensive and Cyclical industries. Lets us look at them in detail over the next few slides, we will take an example of each industry.

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Defensive Industry is a industry which has a ability to provide constant and stable returns, in form of dividend or earnings, regardless of the state of the overall stock market. This is because of the characteristic feature of the defensive industry or stock that the demand of the product like medicine, is not affected much by what is going on in the overall stock market or the economy. The examples of defensive industry may include utility industry like gas and electricity. Other examples may include : food industry ( i.e., basic food items not restaurant industry), water, medicine etc.

Hence, it is generally advisable to invest in defensive stocks a market downturn is expected.

Defensive industry is also known as Non-cyclical industry. Medicine is a good example of defensive industry as if someone is sick, he will take medicine no matter what is the state of the economy or the overall stock market, therefore we will take Pharmaceutical company as a example of defensive industry. In the next slide there is a list of Pharmaceutical companies.

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Lets take an example of defensive industry to understand this better. The industry we are going to consider here is Medicine or Pharmaceutical industry, because the demand of medicine will remain the same, as who-so-ever is ill would like to take medicine and the demand of medicine would not increase when economy is doing better as people would not start eating more medicine because they are earning more, so it remains fairly constant. The table shows

a list of the twelve largest healthcare companies ranked here by revenue as of March 2010 according to their released 2009 annual reports. Johnson and Johnson is on the top with a total revenue of $61,897 millions, followed by Pfizer, Roche and GlaxoSmithKline etc.

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GlaxoSmithKline or GSK for short is the largest Healthcare fortune 500 company, it has been also chosen because it deals in Pharmaceuticals, vaccines, oral healthcare products, nutritional products, over-the-counter medicines etc. Hence suits my requirements of Defensive industry well.

Now, lets see what a cyclical industry is?

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Cyclical Industry is a industry which is sensitive to the business cycle i.e., it is affected by the business cycle boom and bust, for instance the revenue of a cyclical industry are observed to be higher in periods of economic prosperity or expansion and lower in periods of economic downturn and contraction. For example, airlines industry or tourism industry, in good economic times, people have more disposable income and therefore they are more willing to take holidays and travel and if the economy is not doing good or is bad, it is seen that the airlines and tourism agencies lessen their rates, why? Because more of their seats are empty, and they would like to motivate people to spend their money. Other examples may include : Jewellery, Airlines, Manufactures of Heavy Equipment, Expensive cars, Art industry etc.

Hence, it is generally advisable to invest in cyclical stocks if it is expected that market & economy is going to boom.

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Why BMW? Luxury items are good examples of Cyclical industry and luxury cars represent it well and BMW has the largest market share in America in 2011 as per the chart above.

Now in the next few slides we are going to understand fundamental statement analysis in detail and later we will do ratio analysis with the help of these two example i.e., GSK & BMW.

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Now we will discuss, Fundamental Statement Analysis, also known as ratio Analysis. Here we will be discussing import aspects of Fundamental Statement Analysis which is very important part of analysing a company or a stock, we will looks at important parts of a report like director report and Auditors report, also discuss various important ratios.

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The Annual Report of a company is usually broken down into these specific parts:

1. The Director’s Report

2. The Auditor’s Report

3. The Financial Statements and

4. The Schedules and Notes to the Accounts

Lets us look at them in detail in the next few slides.

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The director report as the name suggest gives as various information and details about the company by the company directors for the period under review.

1.To start with it gives us opinion of the directors on the state of the economy and the political situation and how that will affect the company and then

2.Explains the performance and the its financial results of the company which is very important. It also has the results and operations of the various separate divisions, if any, usually in detail so that the investors can determine whether the reasons for the performance of the company.

3.It also gives details about the company’s plans for modernization, expansion and diversification, new acquisitions and investments.

4.Discussions on the profits earned in the period under review and the dividend recommended by the directors and reason for good and bad performance. If the company performance is not good then it is advisable to look into some more information for real reasons for bad performance.

Next in the sequence is the Auditors report.

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It is the auditor’s duty to report to the shareholders and the general public on the stewardship of the company by its directors, hence the auditor report is the only impartial report that one can receive.

Auditors are required to report whether the financial statements presented do in fact present a true and fair view of the state of the company and report changes if any from the previous period, like change in accounting principles or non-provision of charges that result in an increase or decrease in profits.

Sometimes, to show better result some companies might change their accounting practices, these might not be reflected even in notes to the accounts but the Auditor’s Report should show these changes and their effect, hence leading the investor to take better view of the results of a company. This is why reading Auditor’s Report is quite important.

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The published financial statements of a company in an Annual Report consist of :

1.Its Balance Sheet as at the end of the accounting period detailing the financing condition of the company on that date and

2.the Profit and Loss Account, also known as the Income Statement summarizing the activities of the company for that accounting period and

3.the Statement of Cash Flows for that accounting period.

These are discussed in detail in the next few slides, we will start by looking at the balance sheet first.

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Balance Sheet is an important financial statement and tells us about the financial position of a company on a particular date. So, the financial position of a company can be materially different on the next day or the day after that.

In a balance sheet, the Company’s assets (that company owns) and liabilities (that company owes to others) are grouped logically under specific heads.

The next slide presents the basic accounting equation.

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The basic Accounting Equation is Asset of a company are equal to the liabilities it owes to others + the Capital invested by its Shareholders.

i.e., The basic Accounting Equation is

Asset = Liabilities + Capital

Or

Asset – Liabilities = Shareholders Equity

Or

A = L + C

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The income Statement is also known as, the Profit and Loss account, and is also an important financial statements, which basically summarizes the activities of a company during an accounting period which can be a month or a quarter or six months or a year or even longer, and the result achieved by the company.

It gives you details about the income earned by the company, its cost and the resulting profit or loss. Therefore, it is in effect, the performance appraisal not only of the company but also the management of the company - its competence, foresight and ability to lead.

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Schedules and Notes to the Accounts are an integral part of the financial statements of a company and it is very important to read them along with the financial statements of a company as they tell you more information about the set of number you might be seeing in the financial statement and hence may help in taking wiser decisions then taking decisions just based on numbers in the financial statements.

Schedules - The schedules detail pertinent information about the items of Balance Sheet and Profit & Loss Account. It also has information relayed to sales, manufacturing costs, administration costs, interest, and other income and expenses. This information is vital for the analysis of financial statements.

The schedules enable an investor to determine which expenses have increased and seek the reasons for the same. Similarly, investors would be able to find out the reasons for the increase/decrease in sales and the products that are sales leaders. The schedules even gives details of stocks and sales, particulars of capacity and productions, and much other useful information.

Notes - The notes to the accounts are even more important than the schedules because they tell us very important information relating to the company. Notes can effectively be divided into three parts:

• Accounting policies

• Contingent liabilities

• Others

Notes and schedules to the account should always be read with the financial statement for the company as they tell us a whole story behind those numbers in the balance sheet and profit and loss account and give us a clearer picture to take financial decisions. Our next statement is Cash Flow statement.

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Cash Flow Statement allows investors to understand how a company’s operations are running, where its money is coming from and how it is being spent.

The basic Structure of the CFS generally has three components, which are:

• Cash Flow From Operations

• Cash Flow From Investing

• Cash Flow From Financing

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Financial Statement Analysis

Hence, a comprehensive financial statement analysis involves in providing important insights into a firm’s performance and/or its standing in the areas of liquidity, leverage, operating efficiency and profitability.

A complete analysis involves doing both time series and cross-sectional perspectives, wherein the:

• Time series analysis examines trends using the firm’s own performance as a benchmark, while the

• Cross sectional analysis augments the process by using external performance benchmarks with Industry or peers or even both, for comparison purposes.

Since it is difficult to compare companies on different sizes, our next slide tell you about the common size statement which solve this problem.

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A common size statement expresses all items of the statement as percentages of a common base figure say, revenue or sales hence helps in comparing two or more financial statements easily of different companies or time periods and help reduce bias that may occur while analysing companies of differing sizes.

Comparative and Common-size Financial Statements are used in order to compare different financial ratios of a firm with

• industry averages &

• other peers in the industry

whereas common-size financial statements are used to compare performance of a firm or two firms over time.

We can then compare for example, ratio of sales to cost of goods sold of a firm over 2 time periods or may be compare it with industry average or any other firm.

Financial ratios in isolation mean nothing. We need to observe them change over time or compare financial ratios of a cross section of firms in order to make sense of them. The next step is to compute and analyse different financial ratio of the two firm we discussed earlier but us first discuss a little about Ratio Analysis.

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Analysing the Financial Ratios or commonly known is Ratio Analysis very crucial part of Fundamental Analysis and is a tool used by individuals to conduct a quantitative analysis of information presented in the company's financial statements.

Ratios can be calculated from current period (say, year) numbers in the financial statements etc., can then be used to compare it with

• the previous periods (year’s) ratios of the same company to know how the company is performing as compared to last period (year) or

• the current period (year) ratios of some other companies or the industry, to judge the performance of the company.

There are many ratios that can convey different information about company's performance like the activity, financing and liquidity ratios. Some

common ratios include the price-earnings ratio or the commonly known as P/E ratio or the earnings per share also known as EPS, asset turnover

etc., we will look into some of these in a short while.

In the next section we will understand ratio analysis better with the help of an example GSK as our case study.

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We are now going to understand the important ratios and how to analyse them with the help of two example from each of the industry i.e., Defensive industry and cyclical industry. Our first example will be from the Defensive industry, the company we have chosen is GlaxoSmithKline or GSK for short. In the following slides we are going to discuss more about GlaxoSmithKline, we will look into its history, general information, why we chose it?, its operation , products etc., along with the major ratios.

In the next few slides we will look at background of this firm.

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GlaxoSmithKline plc (GSK) (LSE: GSK, NYSE: GSK) is a British multinational pharmaceutical, biologics, vaccines and consumer healthcare company headquartered in London, United Kingdom. It is the world's fourth-largest pharmaceutical company measured by 2009 prescription drug sales. It was established in 2000 by the merger of Glaxo Wellcome plc and SmithKline Beecham plc.

GSK has a portfolio of products ranges from major disease areas including asthma, cancer, virus control, infections, mental health, diabetes, and digestive conditions etc. to oral healthcare and nutritional products and over-the-counter medicines including Sensodyne, Boost, Horlicks, and Gaviscon.

GSK has a primary listing on the London Stock Exchange and is a constituent of the FTSE 100 Index. As of 6 July 2012, it had a market capitalisation of £74.8 billion, the fifth-largest of any company listed on the London Stock Exchange. It has a secondary listing on the New York Stock Exchange.

The next slide covers the general information about GSK.

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This is the General Information about GlaxoSmithKline, as we have already discussed it is a Pharmaceutical company, Chris Gent is the Chairman and Andrew Witty is the Chief Executive. The company established in the year 2000, now has a revenue of £27.387 billion, in 2011.

In the next slide, we will look at the history of the firm, history of a firm tells a lot about its management and how it has grown over the years.

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This is the history of growth of GSK from 2000 – 2011, where Glaxo Wellcome & SmithKline Beecham announced their intention to merge on 17 January 2000 and form GSK, but there is always more importance placed on the recent events of the firm for taking an investment decision, in the next slide is the continuation of this slide and we will look at the history of GSK from 2011 till present.

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Since 2011 till present, you can see in that GSK has plan for diversification, the management of the company is actively involved in making financial decisions for example it is looking into selling some non core brands and invest in manufacturing facilities etc.

In the next slide we will look at the operations of the firm, which gives a little more idea about the firm.

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This particular slide gives some idea about the company’s operation, i.e., what is actually the company does? How big is it? where is its presence, how big the brand is? etc. For example if the brand has its presence in many countries then it may be a big and well diversifies brand, the risk factor that may only affect a country may not affect that brand that much. We will look into the presence of GSK in the next slide.

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These are the major place and products where GSK has its presence, kindly spend 1 minute reading this information.

In the next slide we will look at the product portfolio of GSK.

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These are the major products in GSK portfolio. Apart from medicines , GSK is also into personal care products including Aquafresh, Macleans, Biotene and Sensodyne toothpaste and related product ranges.

The next slide covers the corporate affair’s of the company.

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This slide tells you about where all the company is listed in the stock market and the people who are in top management of the company or the people responsible for taking major decisions. The next slide will cover another important aspect of a company i.e., the Corporate social responsibility of the company.

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We can see from the above slide that the firm has committed itself to Disease eradication and diversity, which shows that the firm is socially resposible.

All this is good but let us now come to more important part of analysis, i.e., the ratio analysis. In the next slide we are going to see the categories of financial ratio.

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There are the five categories of financial ratio, that are:

1. Activity Ratios : these ratios measures how well or efficiently a company performs day to day tasks like the collection of receivables & management of inventory etc.

2. Liquidity ratios : these ratios measures the company’s ability to meet its short term obligations

3. Solvency ratios : these ratios measures the company's ability to meet long term debt obligations.

4. Profitability ratios : these ratios measures the company's ability to generate profitable sales from its (resources) assets.

5. Valuation ratios : these ratios measures the quantity of asset or flow associated with ownership of a specific claim

But all the ratios are not important, there are three major types ratios, i.e.,:

• Liquidity

• Solvency

• Profitability

Which can provide clues to underlying conditions that may not be apparent from an inspection of the individual components. These ratio, if considered singly may not be very meaningful but when combined with other ratio’s and information, may convey great deal of useful information. Hence should be use in combination of other ratio, information etc. Now, in the following slides, we are going to discuss these ratios in detail, we are going to cover the important ratio in the next few slide.

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The first type that we are going to discuss are Liquidity ratios.

Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations. This is done by comparing a company’s most liquid assets (or, those that can be easily converted to cash) and its short term liabilities.

In general, the greater the coverage of liquid assets to short-term liabilities, the better it is, since it gives a signal that a company can pay debts that are going to become due in the near future without letting it affect its on-going operations. On the other hand, a company with a low coverage rate should raise a red alert for the investors as it may be a sign that the company will have difficulty meeting running its operations, as well as meeting its debt obligations. The biggest difference between each ratio is the type of assets used in the calculation. While each ratio includes current assets, the more conservative ratios will exclude some current assets as they aren’t as easily converted to cash. The ratios that we’ll look at are quick and operating cash flow ratios. So, lets start by looking at the Quick ratio in the next slide.

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The quick ratio is also known as quick assets ratio or acid-test ratio, it is a liquidity indicator that measures the amount of the most liquid current assets there are to cover current liabilities. A higher ratio means a more liquid current position.

The formula as you can see on the screen is :

Quick Ratio = Cash & Equivalent + Short-Term Investment + Accounts Receivables

Current Liabilities

Or

Quick Ratio = Current Asset – Inventories

Current Liabilities

It ignores inventories because inventories is the least liquid element in the current assets.

In the next slide we will calculate the Quick Ratio for the GSK.

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As you can see on the screen the Quick Ratio for GSK has declined slightly.

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The operating cash flow ratio can gauge a company's liquidity in the short term. It is a measure of how well current liabilities are covered by the cash flow generated from a company's operations. Using cash flow as opposed to income is sometimes a better indication of liquidity simply because, as we know, cash is how bills of the company are normally paid off and the higher the ratio the better it is.

The formula, for Operating Cash Flow Ratio, as you can see on the screen is

OCF Ratio = Cash Flow from Operations

Current Liabilities

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Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts, as you can see from the screen the ratio is declining for GSK from the past year and is low, it is not very good.

Our next category is Solvency ratio, which we will



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