This chapter mostly reviews material from the fundamental analysis chapter. There is some new content here, but you can treat most of it as a refresher.

There are various ways an investor can analyze a security to decide whether it’s worth investing in. Broadly, analysis falls into two main categories: fundamental analysis and technical analysis.

Fundamental analysis is a traditional approach that focuses on a company’s business and financial condition - revenues, expenses, debt levels, and product and/or service lines. Publicly traded companies must disclose financial information quarterly, and analysts use those disclosures to evaluate the company.

Stockholders have the right to inspect a company’s books and records. In practice, that right is largely satisfied through required financial disclosures such as:

10-K annual report

• Audited financial report
  • Example: Tesla 10K filing

10-Q quarterly report

• Unaudited financial report
  • Example: Microsoft 10Q filing

In these reports, fundamental analysts review financial statements to estimate a company’s value. The most commonly analyzed statements are:

Balance sheet

• Compares assets and liabilities
• Assets - liabilities = net worth

Income (cash flow) statements

• Displays income and expenses

There are differences between income statements and cash flow statements, but the exam generally doesn’t test those details. For exam purposes, you can treat them as providing similar information about money coming in and going out.

Sidenote

Auditor disclosures

Financial disclosure forms like Form 10-K must be audited by an independent third party (typically an accounting firm). The auditor’s job is to review the issuer’s financial statements and determine whether they are complete and accurate.

The auditor must include these disclosures on the forms they audit:

• The issuer is responsible for providing the financial statements and data
• The auditor is responsible for providing an opinion on the supplied financial data
• The auditing standard used by the auditor*
• The auditor’s opinion on the financial data

Auditing standards set the methods and requirements used when an audit is performed. A common standard is Generally Accepted Auditing Standards (GAAS).*

The most important part of the auditor’s disclosures is the opinion. In the best-case scenario, the auditor issues an unqualified opinion. The Tesla 10-K linked above includes an unqualified opinion:

“In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of [Tesla, Inc.]…”

That quote is an example of an unqualified opinion, meaning the auditor believes the financial statements fairly and accurately reflect the issuer’s financial situation.

If the auditor believes the statements are misleading or omit a material item, the auditor issues a qualified opinion. A “qualifier” is an added message that limits or weakens the original message. For example, compare:

• Unqualified: “I am good at studying.”
• Qualified: “I am good at studying, but only if I don’t have access to video games.”

A qualified auditor’s opinion works the same way, but in financial terms. There are several possible reasons for a qualified opinion - for example, misrepresented financials, an asset or liability not properly reflected, or improper accounting methods. Regardless of the cause, a qualified opinion reflects poorly on the issuer and is typically a major concern for shareholders.

Balance sheets

It’s often easier to understand financial statements by translating them into personal terms. You could create a personal balance sheet by listing your assets (things you own) and liabilities (things you owe). The difference is your net worth. For example:

Assets	Liabilities	Net worth
$250k home	$200k mortgage
$20k car	$10k car loan
$5k cash
$275k	$210k	$65k

This person has $275,000 of assets and $210,000 of liabilities, leaving $65,000 of net worth.

Companies track assets and liabilities in the same basic way (just with many more categories and line items). You don’t need to be an accounting expert for the exam, but you should be comfortable with the structure of a corporate balance sheet. Here’s a simplified example:

Assets

Current assets = $125,000

• Cash and cash equivalents - $100,000
• Accounts receivable - $15,000
• Inventory - $10,000

Fixed assets = $350,000

• Real estate - $150,000
• Equipment - $80,000
• Land - $120,000

Intangible assets = $50,000

• Copyrights - $30,000
• Patents - $20,000

Liabilities & shareholder’s equity

Current liabilities = $100,000

• Accounts payable = $40,000
• Wages payable = $30,000
• Taxes payable = $20,000
• Interest payable = $10,000

Long-term liabilities = $150,000

• Debentures = $100,000
• Mortgage bonds = $50,000

Stockholder’s equity = $275,000

• Preferred stock = $80,000
• Common stock = $150,000
• Capital in excess of par = $25,000
• Retained earnings = $20,000

Even though there are many line items, the categories follow a few core ideas. Here are the balance sheet items you’ll want to recognize:

Current assets and liabilities
“Current” means short term (generally within one year).

• Current assets are already cash or can reasonably be converted to cash within a year. Examples include cash, cash equivalents (like a money market fund), accounts receivable (money owed to the company within one year), and inventory.
• Current liabilities are due now or must be paid within a year. They often include items with the word “payable.” “Payable” means the company owes a payment in the near term.

Fixed assets
Long-term tangible assets, such as real estate, property, vehicles, and equipment.

Intangible assets
Long-term non-physical assets, such as trademarks, patents, copyrights, and other intellectual property.

Long-term liabilities
Obligations that extend beyond one year, such as longer-term loans, bonds, and mortgages.

Stockholder’s equity
Equity represents ownership. Stockholder’s equity commonly includes outstanding stock, capital in excess of par, and retained earnings.

• Capital in excess of par is the amount investors pay above a security’s par value. For example, if an issuer sells $100 par preferred stock for $102 per share, $2 per share is credited to capital in excess of par.
• Retained earnings are earnings the company keeps rather than distributing to stockholders. If a company earns $100,000 and distributes $80,000 to common and preferred stockholders, it credits $20,000 to retained earnings*.

*The $20,000 of retained earnings in this example would be added to any unspent retained earnings accumulated over previous years.

Balance sheets ultimately show net worth, also called stockholder’s equity. The formula is:

$\text{Net worth}=\text{assets - liabilities}$

Can you calculate the net worth using the total assets and liabilities above?

The process is straightforward: add up total assets, add up total liabilities, then subtract liabilities from assets.

Balance sheet formulas

Several common formulas use current assets and current liabilities to measure a company’s liquidity (its ability to access cash to meet short-term obligations).

Current assets and liabilities

Current assets typically include cash, cash equivalents (like money markets), accounts receivable, and inventory. Accounts receivable are payments the company expects to receive soon for goods or services already provided. In other words, if the company has cash - or something that can reasonably be turned into cash soon - it’s usually a current asset. These are the current assets from the earlier example:

Current assets = $125,000

• Cash and cash equivalents - $100,000
• Accounts receivable - $15,000
• Inventory - $10,000

Current liabilities typically include accounts payable, wages payable, taxes payable, and interest payable. These are short-term bills the company must pay, such as costs of goods, operating costs (general business costs), interest on outstanding loans (including bonds), and taxes. If it must be paid within a year, it’s generally a current liability. These are the current liabilities from the earlier example:

Current liabilities = $100,000

• Accounts payable = $40,000
• Wages payable = $30,000
• Taxes payable = $20,000
• Interest payable = $10,000

Current ratio

The current ratio compares current assets to current liabilities. Companies use it to gauge their ability to meet short-term obligations.

A personal analogy helps: the current ratio is like asking whether you could cover a large unexpected bill using the resources you can access in the near term.

The formula is:

$\text{Current ratio}=\frac{\text{current assets }}{\text{current liabilities}}$

Using the example above, can you calculate the current ratio?

If the current ratio is above 1, the company has more short-term assets than short-term liabilities. If it’s below 1, the company doesn’t have enough short-term assets to cover its short-term liabilities, which is generally a warning sign.

Net working capital

Another common measure is net working capital. Instead of a ratio, it gives a dollar amount of net short-term resources.

$\text{NWC}=\text{current assets - current liabilities}$

Using the same numbers as above, can you calculate net working capital?

Here, the company has $25,000 more in current assets than current liabilities. That cushion can help if an unexpected short-term obligation comes up.

Quick formulas

The term “quick” refers to short-term finances. These formulas focus on liquidity - how much cash and near-cash the company has available. Liquidity matters because short-term obligations often need to be paid quickly.

First is the quick assets formula:

$\text{QA}=\text{current assets - inventory}$

This removes inventory and focuses on cash and other marketable assets. If the company needs to make a sudden payment, inventory may not be helpful unless it can be sold quickly.

Next is the quick ratio, also called the acid test ratio. This is a common way to evaluate liquidity because it compares quick assets to current liabilities.

$\text{QR}=\frac{\text{current assets - inventory}}{\text{current liabilities}}$

A higher quick (acid test) ratio indicates greater liquidity. If the ratio is above 1, the company can cover current liabilities using short-term assets without relying on inventory. If it’s below 1, the company may need to sell inventory to meet short-term obligations.

Income statements

Now let’s switch to an income statement. If you’ve ever looked at your bank account activity, you’ve seen a personal version of one: money comes in, money goes out.

Event	Amount
Paycheck from job	$3,000
Groceries	-$100
Mortgage payment	-$1,500
Total	+$1,400

After these three events, this person has $1,400 of positive cash flow.

Companies report income and expenses in a similar way, just with many more line items. Analyzing income statements helps you understand how well a company generates revenue and controls costs.

Here’s a simplified corporate income statement:

Line item	Amount
Sales revenue	+$200,000
Cost of goods sold (COGS)	-$80,000
Gross profit	$120,000
Operating expenses	-$30,000
Income from operations (EBIT)*	$90,000
Interest (bonds & loans)	-$25,000
Income before taxes (EBT)*	$65,000
Taxes	-$10,000
Net income	$55,000
Dividends paid	-$20,000
Retained earnings	$35,000

*EBIT = earnings before interest & taxes
*EBT = earnings before taxes

This statement shows the company earned $200,000 in sales revenue and ended with $55,000 in net income after paying for inventory (COGS), operating expenses, interest, and taxes. Then it paid $20,000 in dividends, leaving $35,000 as retained earnings.

As with the balance sheet, the exam focus is usually on recognizing what the major line items represent, not memorizing every possible subcategory.

Financial statements don’t always explain why a number changed. For example, if a company reports a sharp increase in cost of goods sold compared with prior periods, you’d want context. Companies provide that kind of explanation in the footnotes to the financial statements. It might look like this:

Cost of goods sold (COGS) increased by 250% due to costs related to COVID-19 safety measures. Additional capital was spent on various items, including additional personal protective equipment (PPE), additional liability insurance, and cleaning supplies.

Sidenote

Cash vs. accrual accounting

Companies generally use one of two methods to account for revenues and expenses.

With cash-based accounting, revenues and expenses are recorded when cash actually changes hands. For example, the cost of paying for ice cream cones is recorded when the cones are paid for.

With accrual-based accounting, revenues and expenses are recorded when they are created, even if cash payment happens later. For example, the cost of paying for ice cream cones is recorded when the order is placed, even if payment won’t occur for several weeks.

Although it can be difficult (especially for large organizations with complex structures), a company can switch from one method to another at any point.