This chapter is mostly a copy of what you already learned in the fundamental analysis chapter. However, there is some new content in this chapter, but most of it should serve as a review.

There are various ways an investor can analyze a security to determine if it’s worthy of an investment. Generally speaking, there are two big categories of analysis: fundamental analysis and technical analysis.

Fundamental analysis is a traditional approach to analysis that pays close attention to a company’s revenues, expenses, debt levels, and product and/or service lines. Publicly traded companies are required to disclose their financials on a quarterly basis, which is where analysts gather this information. Stockholders have the right to inspect the books and records of a company, which is fulfilled through these financial disclosures:

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 comb through financial documents to determine a company’s value. The most commonly analyzed documents are:

Balance sheet

Compares assets and liabilities
Assets - liabilities = net worth

Income (cash flow) statements

Displays income and expenses

There are small differences between income statements and cash flow statements, but the exam generally does not cover them. Keep it simple and assume both provide the same information.

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 responsibility is to collect financial data and statements from the issuer and determine the completeness and accuracy of the provided information. The assigned auditor must provide the following 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 determine the methods and requirements used when an audit is performed. A common standard is Generally Accepted Auditing Standards (GAAS).

The most important piece of the auditor’s disclosures is the opinion. In the best-case scenario, an unqualified opinion is provided. 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.]…”

The quote above is an example of an unqualified opinion, which means the auditor believes the financial statements completely and accurately reflect the issuer’s financial situation. If the auditor believed the statements were misleading or didn’t include a material item, they would issue a qualified opinion. A ‘qualifier’ is an added message that reduces the effectiveness of the original message. For example, let’s start with the statement, “I am good at studying.” This is an unqualified statement. If it’s changed to “I am good at studying, but only if I don’t have access to video games,” the added qualifier makes it a less impactful statement.

A qualified auditor’s opinion is similar to the statement above, but using money-based language. There could be several reasons for a qualified opinion - the issuer’s financials are misrepresented in their statements, an item (e.g., an asset or liability) is not properly reflected, proper accounting methods are not being used, etc. Regardless of the reason, a qualified opinion reflects poorly on the issuer and will likely be a big concern for shareholders.

Balance sheets

Sometimes it’s easier to understand these financial documents when we think about them in personal terms. You could create a personal balance sheet if you documented all of your assets (things you own) and liabilities (things you owe), which would provide your own personal net worth. For example:

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

This is a simple personal balance sheet. This person has $275,000 of assets, $210,000 of liabilities, which leaves them with $65,000 of net worth. Companies account for assets and liabilities similarly (although it’s much more complicated), which leads analysts to a company’s overall value.

Corporate balance sheets are more complicated, but are fundamentally the same as a personal balance sheet. You won’t need to be an accounting expert for the exam, but it’s important to feel comfortable with the basics of a corporate balance sheet. Here’s a quick example of one:

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

It might seem complicated, but remember you only need to know the basics. There are a few specific balance sheet items to be aware of:

Current assets and liabilities
The term “current” translates to “short term.” Current assets are either currently cash or can be reasonably turned into cash within a year, which include cash, cash equivalents (like a money market fund, accounts receivable (money owed to the company within one year), and inventory. Current liabilities are either currently due or must be paid off within one year, which include items with the term ‘payable’ in them. Payable refers to a payment the company must make in a short period of time.

Fixed assets
These are long-term tangible assets, which typically include real estate, property, vehicles, and equipment.

Intangible assets
These are long-term intangible (non-physical) assets, which typically include trademarks, patents, copyrights, and other forms of intellectual property.

Long-term liabilities
The name gives away this category. Long-term liabilities typically include loans that last longer than a year, bonds, and mortgages.

Stockholder’s equity
Equity relates to ownership. Stockholder’s equity typically includes outstanding stock, capital in excess of par and retained earnings. Capital in excess of par is the amount paid above the par value for an investment. For example, let’s assume an issuer sells $100 par preferred stock for $102 per share. The stock sale would credit $2 to capital in excess of par for every share sold. Retained earnings is the amount of earnings not distributed to stockholders. If a company makes $100,000 of earnings and distributes $80,000 to common and preferred stockholders, they’ll credit $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 provide net worth, also known as stockholder’s equity, which helps determine the overall value of a company. The formula is:

$Net worth = assets - liabilities$

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

(spoiler)

$Net worth = assets - liabilities$

$Net worth = $525,000 - $250,000$

$Net worth = $275,000$

It takes a little math, but it’s not a complicated formula. Add up all the assets and liabilities, then find the difference.

Balance sheet formulas

Let’s discuss the various formulas derived from the balance sheet that utilize current assets and liabilities in order to determine a company’s liquidity (access to cash).

Current assets and liabilities

Current assets typically include cash, cash equivalents (like money markets), accounts receivable, and inventory. Accounts receivable are payments for goods or services the company expects to receive shortly. Basically, if a company has cash or something that can reasonably be turned into cash shortly, it’s considered a current asset. These are the items listed as current assets from the example in the previous section:

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. All of these relate to bills the company must pay within a short period of time. These expenses relate to the cost of goods, operation costs (general business costs), interest costs on outstanding loans (including bonds), and paying taxes. Basically, if something needs to be paid for within a year, it’s considered a current liability. These are the items listed as current liabilities from the example in the previous section:

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 and current liabilities. Companies use this ratio to determine their ability to handle short-term obligations. From a personal perspective, the current ratio would tell you if you could pay off a large bill if it came unexpectedly. If you can, great! If not, you’ll need to consider borrowing some money.

Corporations think the same way. How equipped are they if a large expense comes out of nowhere? The current ratio helps tell that story. This is the formula:

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

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

(spoiler)

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

$Current ratio = \frac{$125,000}{$100,000}$

$Current ratio = 1.25$

If you were to think about the numbers, it’s always better to have more assets than liabilities. If the current ratio is above 1, the company has more short-term assets than liabilities. If it’s less than 1, the company does not have enough short-term assets to cover its short-term liabilities. This isn’t ideal!

Net working capital

There’s another formula that involves current assets and liabilities. Net working capital doesn’t involve a ratio, but instead provides a specific amount of net assets or liabilities. Here’s the formula:

$NWC = current assets - current liabilities$

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

(spoiler)

$NWC = current assets - current liabilities$

$NWC = $125,000 - $100,000$

$NWC = $25,000$

Instead of providing a ratio, we get a tangible number. If this company were to face an unexpected liability, they have $25,000 of short-term assets that will help them pay for it.

Quick formulas

The term ‘quick’ refers to short-term finances. Each of the quick formulas in this section aims to measure the liquidity of a company. The more liquid a company is, the more cash and marketable assets they have on hand. When an unexpected payout is due, liquidity is important.

First, we’ll look at the quick assets formula:

$QA = current assets - inventory$

By taking out inventory, the company is only focusing on cash and its marketable assets. If the company is forced to make a sudden, unexpected payout, its inventory probably won’t help (unless it’s very easy to sell its product). The quick assets formula is like looking in the wallet of a company.

There’s also a quick ratio, which is also known as the acid test ratio. This ratio is one of the best ways to determine the liquidity of the corporation because it factors in short-term liabilities as well.

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

The higher the quick (acid test) ratio, the more liquid a company’s finances are. If the ratio is above 1, the company has enough short-term assets without including inventory to pay off its short-term liabilities. If it’s lower than 1, the company may sell some of its inventory to pay its short-term obligations.

Income statements

Let’s switch gears and look at an income statement. If you’ve ever inspected your bank account, you’ve seen your own version of one. Income statements focus on the inflow and outflow of money. For example:

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

This is a simple personal income statement. After three events, this person has $1,400 of positive cash flow. Companies compile and disclose cash flow in a similar way, with many more line items. Analyzing income statements provides data on a company’s revenues and expenses, which help determine how well a company is selling its products & services and spending its money.

Similar to a balance sheet, the corporate version of an income statement is more complicated. Here’s an example of one:

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

Income statements depict the cash inflows and outflows of a company. In the example above, the company sold $200,000 of product, but ended with $55,000 in net income after paying for inventory, operational expenses, interest, and taxes. From there, the company paid $20,000 in dividends to shareholders, leaving them with $35,000 of retained income. Similar to a balance sheet, it’s important to know the items that are included on an income statement, not necessarily the specifics of the line item.

Financial statements don’t always do a great job of providing detailed information. For example, what if a company suddenly reported a sharp increase in the cost of goods sold as compared to previous income statements? There could be a legitimate reason for this, like a global pandemic requiring more safety measures, resulting in rising costs. If providing details is necessary, companies provide this context in the footnotes of their financial statements. It might sound something 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

One of two methods can be used when a company accounts for its revenues and expenses. When cash-based accounting is utilized, revenues and expenses are accounted for when a cash flow occurs. For example, the cost of paying for ice cream cones would be realized when it is paid for. Conversely, accrual-based accounting accounts for revenues and expenses as soon as they are created. For example, the cost of paying for ice cream cones would be realized as soon as the order is made, even if the payment will not occur for several weeks.

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

Key points

Fundamental analysis

Inspection of a company’s finances

Balance sheet

Compares company assets and liabilities
Indicates a company’s net worth

Net worth

Determines overall value of company or person
$NW = assets - liabilities$

Income (cash flow) statement

Displays company income and expenses

Footnotes

Provides additional context for the information in financial statements

10-K annual report

Audited financial report

10-Q quarterly report

Unaudited financial report

Current assets

Assets able to be converted into cash within one year

Current liabilities

Liabilities owed now or will be within one year

Current ratio

$CR = \frac{current assets}{current liabilities}$
Measures ability to pay short-term obligations

Net working capital

$NWC = current assets - current liabilities$
Determines liquid cash and marketable assets on hand

Quick assets

$QA = current assets - inventory$

Quick ratio

Also known as the acid test ratio
$QR = \frac{current assets - inventory}{current liabilities}$
Used to determine a company’s liquidity

Cash-based accounting

Companies account for revenues and expenses when a cash flow occurs

Accrual-based accounting

Companies account for revenues and expenses when they are created (even pre-cash flow)