Economic Analysis

Every common stock is susceptible to the market risk. This feature of almost all types of
common stock indicates their combined movement with the fluctuations in the economic
conditions towards the improvement or deterioration.

Stock prices react favorably to the low inflation, earnings growth, a better balance of trade,
increasing gross national product and other positive macroeconomic news. Indications that
unemployment is rising, inflation is picking up or earnings estimates are being revised downward
will negatively affect the stock prices.

However, the following economic factors are vital and investors should monitor them while
making investment decision.
1. Growth of the Economy
An investor should consider the position of the national economy while making investment
decision. Gross national product (GNP), net national product (NNP), and gross domestic product
(GDP) etc. are the sophisticated measures or indicators of the total income or total output of the
country. The growth rates of these indicators indicate the growth rates of the economy. An
economy has typically four stages like depression, recovery, boom and recession
 Depression is the worsened situation of the economy where demands become low,
inflation and interest rates often tend to be unexpectedly high.
 Recovery: When demands pick up leading to more investment, the position of the
economy is termed as recovery. At this stage production, employment, and profits tend to
increase.
 Boom: In a boom position, demands increase, production rate would become higher;
profits of the companies would become higher.
 Recession: In the time horizon, the economy will downturn in demands, production, and
employment. As a result, the profits of the company start to decline. This position of the
economy is called recession.
2. Interest Rates
Interest is the cost of funds borrowed by the company for investment purpose. Interest rates
determine the cost and availability of the credit of the company. A lower rate of interest
stimulates investors to borrow money from the market easily at a cheapest cost to finance which
generates higher profit. It implies that in a regime of low interest investors have the opportunities
to earn higher profit
Higher interest rates, on the other hand, result in higher cost of production leading to lower
profitability and lower demand as well. Interest rates, being a most crucial determinant of stock
price, are the basic component of discount rates with the two usually moving together. Therefore,
interest rates can influence the price of a stock as well as the investment decisions of the
investors.
 3. Inflation
Inflation measures the percentage change in a specific cost of living index at various points in
time. It is the situation of the economy where the price of the essential commodities increases
generally keeping the purchasing power of money lower.
An economy with higher inflation can upset business plans resulting in a squeeze on profit
margin as a result of the lower demand for the products. This situation of the economy affects the
performance of the company adversely. In an economy with lower inflation, company
experiences growth and development. An investor in the financial market should evaluate the
inflation rate prevailing in the economy and also the expected rate of inflation in near future.
4. Savings Rates
The theory of economy says that the savings of individuals as well as the society as a whole are
converted into investment so the money saved can offset the rate of inflation. Saving is the
amount of postponed consumption. Thus, savings rates can affect the price of the stock and the
investment decisions of the investors as well.
5. Monetary and Fiscal Policy
Financial theory asserts that dividend policy of a firm is closely related to the movement of
macroeconomic factors. The uncertainty of fiscal and monetary policy is significantly correlated
to earnings of the firm, which is also related with the amount of its dividend payments.
Monetary and Fiscal Policy of the government can influence the performance of the company.
Monetary policy controls the credit and keeps the supply of money at an optimum level which
affects the borrowings of the company. As interest rates of the economy are controlled by the
monetary policy, it affects the profitability of the company which in turn affects the price of
stock. Fiscal policy, on the other hand, influences the performance of the company. Stock price
is affected by the clientele effect. If any income from the securities in the form of dividends and
capital gains are treated as taxable income in an economy with market imperfections.
6. Taxes
Economists argue that the corporate tax as well as dividend policy is irrelevant to the value of the
firm. If dividends are taxed more heavily than capital gains, investors would be habituated to
invest in stock with low dividend yield and hence they should accept a lower pre-tax rate of
return from securities offering returns in the form of capital gains rather than dividends.
7. Foreign Exchange Rates
The profitability of the company is affected by the exchange rates of local currency against the
currencies of the rest of the world
Large foreign exchange reserves help increasing the value of local currency against the other
currencies. The balance of trade deficit, the balance of payment deficit, and the foreign exchange
reserves of the country will help to predict the future trends in exchange rates which in turn helps
investors in making investment decision.
8. Infrastructure
To some extent, the development of economy depends on the infrastructure like electricity, roads
and railways to transfer raw materials and finished goods, communication network to keep in
touch with suppliers and customers. These infrastructure facilities affect the performance of the
company as the productivity depends upon them. An investor should consider the infrastructure
facilities an industry as well as a company requires while making investment decision.
9. Investment Environment
In an agro-based economy like Bangladesh, the performance of some industries and companies
depends on the performance of agriculture because of the strong forward and backward linkages
agriculture and industry. Moreover, the performance of the agriculture to a very great extent
depends on the monsoon. The adequacy of the monsoon determines the success or failure of the
agriculture of a country like ours.
10. Investment Policy of the Government
No industry and company can grow and prosper in the midst of political turmoil. Government
intervention obviously influences the investment decisions of the investors. A sound and smooth
government policy for industrialization will help establishing companies.
11. Political Stability
For a steady, smooth and stable economic growth, a stable political regime is essential. A stable
government policy with long-term objectives will be required for better performance of the
economy, industry and company. Political unrest is not desired at all for better economic
performance.
Economic Forecasting
Being the first stage of the fundamental analysis, economy analysis starts with an analysis of the
historical performance of the economy. Investors are very much optimistic about the future
performance of the economy and its various segments. Forecasting the economy is very
important activity in the economy analysis. An investor should consider the following situations
of the economy while forecasting the economy in near future:
i. Recession and higher rate of interest
ii. Recession and lower rate of interest
iii. Boom and higher rate of interest
iv. Boom and lower rate of interest
The key macro-economic variables affecting the price of stock can be
Fiscal policy
Monetary policy
Corporate tax rate
Output of the economy
Interest rates
Inflation rate
Savings rate
 General price level changes
Changes in real output
Changes in money supply
Corporate earnings
Changes in total earnings
Enterprise/industry performance
Forecasting Methods
Forecasting is the method of predicting about the position of the economy. This type of
preassumption about the economy can be carried out for short-term periods, medium-term
periods, and long-term periods. Whatever the term may be an investor should be more concerned
about the objectives of the economic forecasts. Some methods of economic forecasting are
discussed below:
Anticipatory Surveys
Anticipatory surveys are the surveys of intentions of people in government, business, trade and
industry regarding their consumption activities, plant and machinery expenditures, level of
inventory future plans of consumers, with regard to their spending on durables and non-durables
etc. Based on the results of these surveys, the investors as well as analysts can form the forecast
of the future state of the economy. Surveys of the intentions of the consumers regarding the plan
and budget for expenditures in advance can provide valuable inputs to the short-term economic
forecasting.
Indicator Approach
This refers to the technique by which various types of indicators being time series data of certain
economic variables are analyzed to find out how the economy is likely to perform in future.
Econometric Model Building
This is the method using econometrics applied for mathematical and statistical techniques to
economic theory. In econometrics analysis both dependent and independent variables are used.
The relationship between the dependent and independent variables are specified in a
mathematical manner. Thus, economic models can be used for economic forecasting.
Opportunistic Model Building
Commonly known as GNP model building or sectoral analysis, this method is most widely used
forecasting technique. Based on the total demand in the economy, an analyst can estimate the
total income for the forecast period. Taking this estimation into consideration, the existing
economic conditions such as tax rate, interest rate, inflation rate, and other economic policies
including monetary and fiscal policy of the government can be estimated.
Economy and the Stock Market
Stock market plays the pivotal role in the economic development. Stock market performs in the
economy. There exists a strong relationship between the two. In a sound economy, most of the
companies will perform better. Conversely, if most of the companies do better, the economy will
be strengthened. The movements in aggregate economic activities like expansion and contraction
is known as business cycle.
The relationship between stock market and the economy is that, being the most sensitive
indicator of the business cycle, stock prices lead the economy. It may be hypothesized that if
recession exists the market can provide false signal about the future economic activity and the
market can register an increased number of false alarms. The ability of the market to predict
recoveries is much better than its ability with recession.
The theories of macro-economy postulate a relationship between money and future economic
activity with the relationship depending on whether changes in money stock can be attributed to
shifts in money supply or money demand. An increase in money supply leads to an increase in
economic activities. But an increase in money demand leads to reduce economic activities.
Finally, investors should open their eyes on the activities of the government as well as its
agencies because of their role in monetary policy and fiscal policy and their impact on the rates
of interest and other determinants of stock prices.
Determinants of Stock Prices
Although a firm’s industry does not help to explain its dividend payout ratio, economic analysis
can innovate some effect of industry on the dividend policy and the value of the stock as well.
However, it may be noted here that the apparently significant industry effect may exist from the
fact that variables are often similar within a given industry. These similarities are the fundament
reasons why firms in the same industry have similar dividend payouts A classical model to
determine the stock prices identifying exogenous and endogenous variables can be shown by the
flow diagram exhibited in Figure 6.1.

Corporate
tax rate

Changes in
government
spending
Changes in Nominal Real corporate Expected real
total corporate earnings corporate
spending earnings earnings
Changes in
nominal
money Changes in
real money
Stock price
Interest rate
Potential Changes in
output price level

Changes in
real money
Figure-6.1: A Flow Diagram of Stock Price Determination. [Source: C.P. Jones, Investment
analysis and Management
Figure 6.1 shows that the potential output of the economy being the nonpolicy variable along
with three active policy variables- fiscal policy, monetary policy and corporate tax rate
ultimately affect the prices of the stocks. Two independent variables like government spending
(fiscal policy) and money supply (monetary policy) affect the stock prices in two ways:
i. by affecting total spending that along with corporate tax rate affects corporate earnings
which is positively related to changes in stock prices,
ii. by affecting total spending which along with the potential output and past changes in
prices determine current changes in prices which ultimately determine current changes in real
output.
The ultimate determinants of stock prices are present and expected earnings of the corporation
and prevailing interest rates. There exists a strong positive relationship between corporate net
earnings and stock prices. The expected value of the stock and the market as well should be a
function of the expected streams of benefits to be received and the investors’ required rate of
return. Investors will expect corporate net earnings and dividends to rise and as a result stock
price will tend to rise if the economy is prospering. However, the relationship between the stock
price and its determinants are summarized below:
Notion of the determinants Impact on stock price
♦ Interest rates rise (fall). ♦ Stock prices fall (rise).
♦ An increase (decrease) in ♦ Stock prices tend to increase
expected corporate earnings. (decrease).
♦ A change in government ♦ Affects the corporate earnings.
spending.
♦ An increase in tax rate. ♦ Reduces the corporate net
earnings.
♦ An increase in money supply. ♦ Increases the prices of stocks.
♦ An increase in output. ♦ Increases the prices of stocks.
♦ An increase in risk factor ♦ Reduces stock prices.
(discount rate).
♦ An increase (decrease) in ♦ Causes an increase (decrease)
growth of dividend. in stock prices.
4.0Industry Analysis:
It is clear there is certain level of market risk faced by every stock and the stock price decline
during recession in the economy. Another point to be remembered is that the defensive kind of
stock is affected less by the recession as compared to the cyclical category of stock. In
the industry analysis, such industries are highlighted that can stand well in front of adverse
economic conditions.

What is Industry?
The basic concepts of industry analysis are closely related to the various issues of valuation
principles. Investors can apply these concepts in several ways. The amount and clarity of
information, the degree of rigor sought, and the specific model used are usually considered while
someone is assessing the industry performance.
Industry Classification
However, industries are classified on the basis of products what the companies belonging to an
industry produce. Accordingly, industries are categorized as pharmaceutical industry, garments
industry, cement industry, agriculture industry, and so forth
Industry Analysis
All the steps involve in an analysis is called industry life cycle. According to the industry life
cycle theory, the life of an industry might be segregated into the aforesaid stages which are very
much essential to an investor because the profitability of an industry depends on its stage of
growth.
Industry Life Cycle
The concept of industry life cycle can be applied to industries or product lines within industries.
The industry life cycle concept is exhibited in Figure 7.1. which discusses each stage
chronologically.

[1] [2] [3] [4]

 Years
[1] Pioneering stage [3] Stagnation stage
[2] Expansion stage [4] Decay stage

Pioneer stage: a pioneering stage when the new inventions and technological developments take
place. During this time, the investor will notice a great increase in the activity of the firm.
Production will rise and in relation to production, there will be a great demand for the product.
At this stage, the profits are also very high as the technology is new.

Taking a look at the profit, many new firms enter into the same field and the market becomes
competitive. The market competitive pressures keep on increasing with the entry of new firms
and the prices keep on declining and then ultimately profits fall

Expansion stage: Being the second stage of an industry life cycle, an expansion stage identifies
the survivors from the pioneering stage. They continue to grow and prosper though the rate of
growth which is moderate than that in the pioneering stage. Each company finds a market for
itself and develops its own strategies to sell and maintain its position in the market. The
competition among the surviving companies brings about improved products at lower prices.
Companies in the expansion stage of an industry are attractive and suitable for investment
purpose. Since the demand exceeds the supply in this stage, companies create higher returns at
lower risk. The earnings of the companies in the expansion stage increase leaving higher profits
as well as dividends to the company owners
Stagnation stage
In the third stage of the industry life cycle, industries evolve into the stabilization stage at which
the growth begins to moderate. At this stage sales may still be increasing at a much slower rate
than that in the expansion stage. Products become more standardized and less innovative, the
market is full of competitors, and costs are stable rather than decreasing through efficiency
moves. Industries in this stage continue without significant growth. So, the industries in this
stage begin to stagnate. An investor should dispose of his holdings in an industry passing from
the expansion stage to stagnation stage as what is to follow is the decay of the industry.
Decay stage
The last and the final stage of the industry life cycle is the decay stage passing from the
stagnation stage. This stage starts when the product of the industry are no longer in demand. New
products and new technologies have come to the market. Customers have changed their habits,
style, and liking. As a result, the industry becomes obsolete and gradually ceases to exist. Thus,
the changing scenario of the habits of the customers, technologies, and declining demands for the
products are the causes of the decay of the industry. Investors should get out of the industry
before the onset of the decay stage.
Qualitative Aspect of Industry Analysis
After analyzing industry life cycle and business cycle, investors and analysts should give
concentrations to the analysis of the important qualitative factors affecting the characteristics of
an industry. Thus analysis will no doubt, help the investors to analyze a particular industry and
will aid in forecasting future prosperity of the industry. However, the qualitative factors to be
considered include the followings.
Historical Performance
Historical records of performance also influence the industry analysis. Historical records of sales,
growth of earnings, price performance etc should be considered by the investors and analysts
while evaluating the performance of the industry. Past records can provide useful information
about future although they cannot be extrapolated.
Competition
Competitiveness in inter-industry and intra-industry also can provide valuable information in
assessing their future prosperity and prospects. The intensity of competition in an industry
determines that industry’s ability to sustain above-average returns. This intensity is a reflection
of underlying factors determining the strength of the following basic competitive factors:
 Threat of new entrants
 Bargaining power of buyers
 Bargaining power of suppliers
 Rivalry between existing competitors
 Threat of substitute products or services

Government Effects
There are certain industrial and economic policies of the government. Time to time government
imposes rules and regulates the economic and industrial activities of a country. So, government
regulations and actions can provide significant effects on industries. Investors should give
emphasis in assessing the impacts of these effects on the industry.
Structural Changes
Structural changes in the economy can also provide significant influence on industry. If the
country wishes to move from an industrial society to another one, major concerning industries
shall be affected. Under such a situation, new industries with tremendous potential will be
emerging while some traditional industries may never recover their former position. Structural
changes may also occur within relatively new industries.
Industry Characteristics
There are a large number of key indicators characterizing an industry which should be
considered a lot while analyzing by the investors. These characteristics include operational and
structural aspects of the industry some of which are discussed below:
Demand Supply Gap
According to demand-supply rules, additional supply will reduce the profitability and insufficient
supply tends to improve the profitability. As a result, the gap between demand and supply in an
industry seems to become a good indicator.
Competitive Conditions
The magnitude of the competitions among the companies in the industry is determined by
certain competitive forces which include barriers to entry, the threat of substitution, bargaining
power of buyers and suppliers, the rivalry among competitors etc.
Labor Conditions
The labor union in some countries like ours are very powerful and objective oriented. The labor
conditions in the industry under analysis seem to be an important consideration in an economy.
The future prospect of an industry would not become bright the labor of which is rebellious and
is inclined to resort to strikes frequently. It implies that labor unrest in a particular industry will
hamper the growth and development of and even it may destroy that industry.
Permanence
Permanence is defined as a condition related to the products and technology used by a particular
industry. In an economy where the rapid technological change is special phenomenon, the degree
of permanence of an industry is sort of vital consideration in industry analysis.
Government Attitudes
Government encouragement, regulations, and attitudes toward an industry carry an importance
on the prospects of the same. Government encourages some industries by making favorable
legislations that can assist toward achieving growth and development. On the other hand,
government discourages some industries making them difficult to survive by imposing some
rules and regulation very tight.
Raw Materials
The price and availability of raw materials used in a particular industry are considered to become
important factors determining the profitability of that industry. The industries having heavy
dependence on a very few manufacturers or on imports for their raw material supply will suffer
tremendously. So, industry analysis must take into consideration the price and supply of raw
materials and their impacts on the prosperity of the industry.
Cost Structure
The cost structure being the proportion of fixed costs to variable costs claims the importance to
be considered while analyzing an industry. The higher the portion of fixed costs, the higher is the
sales volume necessary to achieve break-even point and vice versa. Lower break-event point,
however, provides higher margin of safety. An investor should choose an industry having a
lower break-event point for investment purpose.
While making investment decisions an investor must evaluate the aforesaid factors. If the factors
discussed above indicate suitable future prospects, the investors might commit funds to that
industry.

5.0 Company Analysis

Company analysis is the final stage of fundamental analysis followed by economy and industry
analysis
Company analysis deals with the estimation of return and risk of individual companies. A sort of
information regarding the company influences the price of the securities of that company. So, a
change of security price of a company is a function of information regarding the company. These
information are of two types namely internal information and external information. Internal
information consists of price data and events made public like annual reports to the shareholders,
private and public statements made by the company officers, the financial statements. These are
information made to the public by the companies regarding operational performance. On the
other hand, external information consists of those generated independently by outsiders of the
companies for example the financial analysts. These are prepared by investment services and
financial press. In company analysis, analysts forecast expected future earnings of the company
which seem to have a direct and powerful effect upon share prices. The trend, stability and
earnings of a company depend upon a number of factors regarding the operational performance
of a company. This process of security analysis is called top-down fundamental analysis.
However, an investor must consider two fundamental values like dividends and required rate of
return or, alternatively, earnings and the price-earning (P/E) ratio while making investment
decisions.

Firm-specific Analysis of Stock Price Movements

Total quality management (TQM) of a firm is the most important factor often highlighted by the
financial analysis of the specialist’s report. TQM refers to fundamental, multidimensional
changes in virtually all aspects of an organization including its culture, structures, leadership
style and patterns, learning environment, reward and recognition systems, and superior
relationships The strategy and quality of company management is recognized as a key
differentiator of corporate performance. The stock market’s assessment of a company’s
management is also an important factor influencing sentiment about the company performance.
To assess strategic direction and financial statement analysis, both investors and analysts would
generally focus on the following key factors:
Quality of Management: The quality of management refers to as the key differentiator of
corporate performance
Product Market Positions: Every business unit should work in the competition market.Company
having weak product market positions is to face with sufficient challenges in order to build
competitive advantage and vice versa. Stock market value is estimated in a world of competitive
product market position.
Accounting Policy: A company’s financial position is shown in the financial statement that
highlights and examines its reported performance and accounting policies. Company’s financial
reports reflect the underlying strength and performance of the company.
Mergers and Takeovers: Inappropriate mergers and takeovers are likely adversely affect the
value of the shares if the management fails to deliver the promised performance. On the other
hand, acquisition favorably affects market value of shares, when management can strengthen
existing core of business. The company may need to issue additional shares in order to finance
acquisitions. Unless there exists an unsatisfied demand for the company’s shares, the issue of
additional shares on the market is likely to depress share price. If a company is expected to raise
additional funds, its share price is likely to be marked down.
Dividend performance: The dividend prospects of an individual company may be at variance
with the likely payout rates in the market. Dividend performance may over-valuate the expected
future value and performance of the company.
Cross-sectional Analysis: In times when the stock market is rising strongly the overall market
price earnings ratio tends to rise and with it the price earnings ratios of companies also rise. The
overall level of the stock market and the market’s view of the sector often affect a company’s
price earnings ratios
Future Earnings Forecasts: Share price and forecast earnings contain substantially similar
information concerning future changes in the value of the company. Hence, it is obvious that
there would be a strong correlation between expected future earnings and share price; as
anticipated future earnings rise, the share price rises and as anticipated future earnings fall, share
price fall. Share price reacts to reported performance when disclosure takes place. Company
announcements like anticipated profits; announcements of potential amount of dividends,
resignation of key managers/personnels may have a profound effect on market sentiments and
share prices.
Fundamental Analysis
Company fundamental analysis includes analyzing the basic financial variables in order to
estimate the company’s investment value commonly known as intrinsic value. Furthermore,
company fundamental analysis needs to analyze data to estimate the price of stocks or shares
using one of the valuation models. To this end, the commonly used model known as dividend
discount model (DDM) is one of the valuable models.
Determinants of Stock Prices
A company’s dividend policy is, therefore, influenced by its investment and financing decisions
and by some influencing factors as well. To gain an understanding of what determines the prices
of a stock, we like to consider in this section of the chapter, what determines the price of
individual stocks. The prices of stocks will be determined by trading among individuals. Even if
these stocks themselves are not directly traded, we can merely infer their prices in a competitive
market from the prices of the stocks that are traded. To understand the stock market accurately,
an investor will find the determinants that affect the prices of the stocks. It is logical to expect a
relationship between corporate profits and securities prices. So, expected earnings and interest
rats are the ultimate determinants of securities prices. The transfer of capital between markets
would raise the interest rates that affect the securities prices in two ways: i) high rate of interest
lessens the firm’s profits ii) interest rates affect the economic activities that affect the corporate
profits.
However, this section will strive at explaining the factors determining firm’s dividend and the
stock price as well.
Expectation of future earning: Market price of a share equates the present value of
expected future returns. The shareholders’ expectation of dividends is generally guided by the
future earnings of the company. It may be assumed that shareholders prefer dividends if
companies use retained earnings inefficiently although transaction costs and taxation
considerations generally favor retentions rather than dividend payments.
Pattern of past dividends: While making dividend decision of a year, firms give
emphasis on the last years’ dividends.
Availability of cash: Cash flow is the most important determinant of dividends. Cash
dividends can only be paid with cash. Thus, a shortage of cash in the bank may restrict dividend
payments.
Corporate earnings: Corporate earnings are considered as the primary determinant of
dividends as they provide the cash flow necessary for payment of dividends. If management
increases the proportion of earnings per share paid out as dividends, shareholders would become
wealthier, suggesting that dividend decision is a very important one. Dividends payments usually
may not exceed retained earnings.
Matter increases stock prices: An increase in payout ratio provide signals to investors a
potential growth in future that increases the value of the firm. A firm would suffer the impact of
negative signal when it decreases dividend payout. Information of changes in earnings with
existing dividend rates is also the most important determinant of firm’s dividend policy.
Interest rates: Existing interest rates affect the profits of the company. Investors always
compare the existing interest rate with dividend income. Comparatively, high rate of interest
influences the investors to invest in fixed income securities like bonds etc. rather than stocks.
Therefore, high rate of interest depresses securities prices.
Transactions costs: Transaction costs incur when the company pays dividends and issue
new shares to finance its investment opportunities. This thing can be considered while making
dividend decision. On the other hand, retentions do not incur transaction costs. Thus the presence
of issuing costs suggests that shareholders should favor retention rather than dividends. But a
shareholder being forced to sell shares for income through lack of dividend must incur selling
costs.
Business expansion: Firm’s investment needs and financing opportunities can influence
its dividend policy. Firms having profitable investment opportunities may prefer to retain a large
fraction of its earnings that causes the payout to be relatively low. According to the theme of
financial analysts, growth companies with abundant investment opportunities should reinvest
their earnings hampering dividend payments. Financial analysts pointed out a number of factors
like shareholders’ expectation, past pattern of dividend payments, cash needs for the company,
current earnings of the company, expectation of future earnings, tax consideration, legal
constraints, and owners’ and capital market consideration which affect form’s dividend policy.
Company Fundamentals Analysis
A] Short-term Solvency or Liquidity Measures:
Short-term solvency ratios provide ifformation about a firm’s liquidity, the power of a company
to meet its current liabilities. It measures the firm’s ability to pay its bills over the short run
without undue stress.
Current assets
Current ratio =
Current liabilities
For the short-term creditors the higher the current ratio the better. A higher ratio indicates
liquidity but it also indicates an inefficient use of cash and other short-term assets. A higher
current ratio enables the company to meet its short-term ob ligations.
Current assets – Inventories
Quick or Acid test ratio =
Current liabilities
The quick ratio represents the ratio of quick assets to current liabilities. It is rigorous measure of
liquidity of a company.
Cash
Cash ratio =
Current liabilities
A very short-term credito is interested in the cash ratio.
Net working capital
 Net working capital to total assets =
Total assets
A relatively low value might indicate relatively low level of liquidity.
Interval Measures = Current asset/ Average daily operating costs

B] Long-term Solvency or Financial Leverage Ratio:

Financial leverage ratios are commonly known as capital structure ratios. These ratios measure
long-term sovlency of a firm. The commonly used long-term solvrncy ratios are as follows:
Total Debt ratio = [Total assets-–Total equity]/ Total assets
Total debt ratio takes into account all debts of all maturities to all creditors.
Debt
Debt-Equity ratio =
Equity
This ratio indicates the relative contribution of debtors and owners to the financing of the
corporate capital. The lower ratio is beneficial for the debtors.
Total assets
Equity multiplier (Leverage) ratio =
Equity
This ratio indicates the multiple of equity to the total assets of the company. The higher the ratio
the better.
Long-term debt ratio = Long-term debt / [Long-term debt + Total equity]
This ratio indicates the contribution of debtors to the financing of the firm’s total assets.
Times interest earned ratio = EBIT/ Interest
This ratio measures the ability of the company to meet its interest payments. The higher the ratio
the better.
Cash coverage ratio = [EBIT + Depreciation] / Interest
The higher the ratio the better.
Fixed charge coverage = Income before fixed charges and taxes / Fixed charges
= [EBIT + Lease payments] /[Lease obligation + Int.Exps.]

C] Asset Management or Asset Turn-over ratio:

The ratios under this measure are also called asset utilization ratios. These ratios indicate how
efficiently a firm uses its assets to generate sales and the returns as well. Showing the
relationship between sales and different types of assets, these ratios measure the efficiency in
asset management. The major ratios under this measure are as follows:
Cost of goods sold
Inventory turn over ratio =
Inventories
All other things remaining same, the higher the ratio is, the more efficiently the firm is managing
inventories. This measure gives some indication of how fast a company can sell its products.
How fast a company can collect its sales is the receivables turn-over ratio which can be
calculated as:
Sales (in credit)
Receivables turn-over ratio =
Receivables
This ratio makes sense if the company can convert it to days. So, days’ sales receivables is
essential and it can be calculated as:
365 Days
Day’s sales in receivables =
Receivables turn-over
This ratio can, subsequently, be called average collection period (ACP) which can also be
defined as Days sales outstanding. This ratio indicates days’ worth of sales uncollected. So,
lower the ratio, the better.
Receivables
Average collection period (Days sales outstanding) =
Average daily credit sales

The lower the period, the better.

Sales
Current asset turn over ratio =
Current assets
The higher the ratio, the better.
Sales
Fixed asset turn over ratio =
Fixed assets
The higher the ratio, the better.
Sales
Tota asset turn over ratio =
Total assets
The higher the ratio, the better.

Sales
Net working capital turn over ratio =
Net working capital

Sales
Debtor turn over ratio =
Average debtors

D] Profitability ratio:
The profotability ratios measure the relative profits of a company. These ratios are calculted by
relating the profits either to sales, or to investment, or to assets, or to equities. The major
profitability ratios are:
i. Ratios related to Sales:

Grofit profit
Gross profit ratio =
Sales

EBIT
Operating profit ratio =
 Sales

Earnings after tax

Net profit ratio =
Sales

Administrative expenses
Administrative expense ratio =
Sales

Selling expenses
Selling expenses ratio =
Sales

Administrative expenses + Selling expenses

Operating expenses ratio =
Sales

Cost of goods sold + Operating expenses

Operating ratio =
Sales

ii. Ratios related to Investments:

Net income
Return on assets (ROA) =
Total assets

Net income
Return on Equity (ROE) =
Equities

EBIT
Return on capital employed =
Total capital employed

ii. Ratios related to Equities:

Net income
Earning per share (EPS) =
No of Shares outstanding

Price per share

Price earning ratio (P/E) =
EPS
 Equities
Book value (BV) =
No of Shares outstanding

Market value per share

Market to book ratio =
Book value per share

E] Overall Profitability Analysis:

D1

Intrinsic value = P0 = k−g

or
P0
¿ E1
Intrinsic value = P0= E1
EPS = ROE ×BV

Du Pont Analysis
Net Assets/Sales = Profit margin
Sales/Assets = Asset turnover
Profit margin × Asset turnover = ROA
Financing plan = Assets + Debts = 1- [Debt/Assets]
ROE = ROA / [1- (Debt/Assets)
Du Pont identity is the popular expression that breaks ROE into three parts:
i. Operating efficiency measured by profit margin
ii. Asset use efficiency measured by total asset turnover
iii. Financial leverage measured by equity multiplier
Therefore,
ROE = [Profit margin] × [Asset turnover] × [Equity multiplier]
= ROA × [Equity multiplier]

Technical Analysis

Technical analysis is frequently used as a supplement to fundamental analysis rather than as a

substitute to it. According to technical analysis, the price of stock depends on demand and supply
in the market place. It has little correlation with the intrinsic value. All financial data and market
information of a given stock is already reflected in its market price. Technical analysts have
developed tools and techniques to study past patterns and predict future price. Technical analysis
is basically the study of the markets only. Technical analysts study the technical characteristics
which may be expected at market turning points and their objective assessment.
Technical analysis is directed towards predicting the price of a security. The price at which a
buyer and seller settle a deal is considered to be the one precise figure which synthesis, weighs
and finally expresses all factors, rational and irrational, quantifiable and non-quantifiable and is
the only figure that counts. Thus, the technical analysis provides a simplified and comprehensive
picture of what is happening to the price of a security. Like a shadow or reflection it shows the
broad outline of the whole situation and it actually works in practice.
Properties of Technical Analysis
The fundamental properties of technical analysis are summarized below:
 Technical analysis focuses on internal factors analyzing the movements of the price of
individual securities or market.
 Technical analysis is purely based on market data made to public.
 The value of a security is determined on the basis of demand and supply factors operating
in the market.
 There are both rational and irrational factors surrounding the demand and supply factors
of a security.
 It focuses on the timing.
 In technical analysis, emphasis is given on price changes.
 Technical analysis is basically designed to detect likely price movements over a relatively
short time.
 Security price behave in a particular direction for some length of time.
 Security prices seem to change on the basis of the changes in the demand and supply
factors.
Framework for Technical Analysis
Technical analysis of analyzing securities can be applied to individual stocks and the aggregate
market as well. Such analysis involves the use of graphs, trading rules and indicators.
Market data called price and volume data are the primary source of technical analysis. The forces
of supply and demand show up in patterns of price and volume. Volume data indicates the
general condition in the market and help assessing its trends. The rising (falling) stock prices are
usually associated with rising (falling) volume showing a positive relationship between price and
volume. On the other hand, a downside movement from some pattern accomplished by heavy
volume would be taken as a bearish sign. The technical indicators are used to assess market
conditions. The analysts seek to understand the sentiment of the investors by examining what is
happening in the market. They also involve in contrary analysis which is an intellectual process
rather than a technique. The following section, however, will discuss technical indicators
concerned with the aggregate market and consider stock price and volume techniques latter on.
According to Charles Dow “The market is always considered as having three movements, all
going at the same time. The first is the narrow movement from day to day. The second is the
short swing, running from two weeks to a month or more and the third is the main movement,
covering at least four years in its duration”
According to Dow Theory there are three movements in the market which are simultaneous in
nature. These movements are summarized below:
1. Primary movements: Primary movement refers to the long-range cycle carrying the
entire market up or down lasting for several years.
2. Secondary movements: Secondary movement refers to the opposite direction
occurring within the primary movement lasting only for a short time like several weeks or
months which is commonly known as correction.
3. Minor movements: Known as third movement minor moves refer to the day-to-day
fluctuations occurring randomly around the primary and secondary movements in the market.
However, Figure 9.1 exhibits the movements in the market where the vertical axis represents
prices of the stock and horizontal axis represents time. The primary trend of the market is
upwards but secondary reactions are in the opposite direction.

Prices Primary trend

Secondary trend

Time

Figure-9.1: Showing the Primary and Secondary Trend Technical Analysis.

Dow Theory, however, technically analyze the movements of security prices based on primary,
secondary and daily price movements.
Bull Market
During the bull market in the first phase the prices of the securities will advance with the revival
of confidence in the future prospect of the business. It refers to the period of time during which
measures of the stock market rise During the second phase, the prices of the securities would
advance due to the higher earnings of the companies. In the third phase, the prices of the
securities would advance as a result of the inflation and speculation. Therefore, during the bull
market the line chart exhibits three peaks as depicted in Figure 9.2.

Prices

Time

Figure-9.2: Phases of a bull market

Each peak is followed by a bottom formed by the secondary reaction and higher than the
previous peak. Each successive bottom is higher than the previous bottom. According to Dow
theory, the formation of higher peaks and higher bottoms indicates a bullish trend.
Bear Market
Bear market refers to a downward primary movement. It is a period of time during which
measures of stock market decline. Unlike bull market, bear market is also characterized by three
phases. In the first phase, the prices of the securities will fall due to abandonment of hopes.