When times are good, stocks are cheap and the bull market is going strong, stock picking often seems an unnecessary skill.

Take the last three years. All the investor had to do was to buy all the Sensex stocks and he would have seen the value of his portfolio quadruple when the Sensex moved up from 3000 to 12000.

But when stocks are expensive and markets start to correct, the virtues of picking the right stocks become clear.

Good stocks will do well and give investors steady returns, while bad ones that go up solely on the basis of market sentiment could plunge downwards equally rapidly. It's very important therefore to pick and choose the stocks you buy.

One of the first things to do in choosing stocks is to consider what are called the 'fundamentals'. This is nothing but a financial analysis of the company and a look at some basic facts: profit, sales, earnings, dividends, assets, loans, products, competition and growth potential.

Here, we look at the financials. Remember that, at bottom, the value of a stock depends on the strength of its financials.

You will have noticed these days that the newspapers are full of advertisements about the annual results of companies. If you want to invest in a stock, these advertisements will be a great source of information.

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Let's take, by way of example, we look at the 2005-06 annual results of Hindalco Industries [Get Quote], the aluminium and copper company of the Kumaramangalam Birla group.

Annual Results
Hindalco Industries
Figures in Rs/million (those in brackets indicate negative figures)

What do these annual results tell us?

• Make a comparison

Don't just look at the numbers because, by themselves, the numbers will indicate nothing. You need to make a comparison. Compare the numbers for the two years line by line. For instance, sales, net profit and gross profit have all gone up.

Net profit is profit after all the expenses and tax that has to be paid has been taken into account.

Gross profit is the difference between revenue from sales and cost of goods sold. This profit figure has not yet taken into account tax and all other expenses.

• Look at percentage growth

Numbers will not reveal the full story but percentage growth does.

For example, the good news is that net profit is up. In fact, the growth in net profit is the most important number to consider. And this is up by 24.5% for the full year.

But gross profit for the year is up only by 10.4%. This is well below the rate of growth in net profit.

• Have expenses gone up?

Which brings us to the expenses. If you look a bit more closely, you'll notice that expenses have gone up handsomely too.

Stocks (supplies and material on hand ready for use) have increased, consumption of raw materials is up a whopping 42.3%, staff costs have risen 12.4%, manufacturing and operational expenses have gone up 15.5% while interest and finance charges have increased by 10.4%.

Gross margin (gross profit/net sales) was 20% in 2005-06, below the previous year's 21.1%. Clearly, cost pressures have led to a squeeze in margins.

• Why have profits increased?

This is a question you must ask. In this case, growth has been achieved by higher net sales, which have risen 19.7%.

Also, effective tax planning played an important role. Note how provision for taxes was much lower in 2005-06. The net profits for 2004-05 included the negative impact of deferred taxes for earlier years.

Deferred tax is the amount of tax postponed from this year to be paid at a later date.

• Look at profits more closely

Have profits gone up only at the net level or at the operating level also?

Operating profit is the profit a company earns from operations before interest payments and taxes are paid. It does not include non-operating income like income from investments, income from the sale of assets or other such income that does not arise from the business.

In the above example, operating profit for 2005-06 is Rs 113,965 (net sales) - Rs 2,439 (other income) - Rs 87,914 (total expenditure) = Rs 23,612 million.

It's different from gross profit because it excludes other income and interest charges.

• Look at revenue from 'Other Income'.

This is income that is not strictly related to the business and cannot be depended upon year after year. It could be rent earned, interest and dividends earned, return on investments, profits from sale of assets or investments, sale of scrap items, income from services and so on.

The question you need to ask is: Has 'other income' been a main contributor to the profits and if so, is the increase in such income sustainable?

• Look at 'Extraordinary Items'

These are expenditures or income that will not incur every year.

For example, it could be compensation paid for Voluntary Retirement Scheme. Or, maybe a division was acquired by another company (this would be a gain while the VRS a loss).

• EPS

Earnings per share is nothing but profit after tax / number of shares.

This has increased to 16.8 (16,555 / 986)

Now that you have grasped the basics, tomorrow we shall look at all of this in even greater detail.