This chapter is a direct copy of what you already learned in the fundamental analysis chapter. Use it as a review.
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 financial condition and business operations - things like revenues, expenses, debt levels, and product and/or service lines. Publicly traded companies must disclose financial information quarterly, which is where analysts get much of their data. Stockholders also have the right to inspect a company’s books and records, and that right is largely satisfied through required financial disclosures such as:
10-K annual report
10-Q quarterly report
In these reports, fundamental analysts review financial statements to estimate a company’s value. The most commonly analyzed documents are:
Balance sheet
Income (cash flow) statements
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.
It’s often easier to understand financial statements by thinking about them in personal terms. You could create a personal balance sheet by listing your assets (things you own) and liabilities (things you owe). The difference between the two 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 won’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:
Current assets = $125,000
Fixed assets = $350,000
Intangible assets = $50,000
Current liabilities = $100,000
Long-term liabilities = $150,000
Stockholder’s equity = $275,000
This can look like a lot at first, but the exam focuses on the basics. Here are the balance sheet categories you’ll want to recognize:
Current assets and liabilities
“Current” means “short term.” Current assets are already cash or can reasonably be converted to cash within one year. Common 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 one year. They often include items with the word “payable,” meaning the company owes a payment in the near term.
Fixed assets
These are long-term tangible assets, typically including real estate, property, vehicles, and equipment.
Intangible assets
These are long-term non-physical assets, typically including trademarks, patents, copyrights, and other forms of intellectual property.
Long-term liabilities
These are obligations that extend beyond one year, such as longer-term loans, 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 investors pay above a security’s par value. For example, if an issuer sells $100 par preferred stock for $102 per share, the company credits $2 per share to capital in excess of par.
Retained earnings is the portion of earnings not distributed 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 a company’s net worth, also called stockholder’s equity. The formula is:
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 sheets also support several formulas that use current assets and current liabilities to measure a company’s liquidity (its access to cash).
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 within a year - it’s usually a current asset. These are the current assets from the earlier example:
Current assets = $125,000
Current liabilities typically include accounts payable, wages payable, taxes payable, and interest payable. These are short-term bills the company must pay within a year. They can relate to the cost of goods, operating costs (general business costs), interest costs on outstanding loans (including bonds), and taxes. These are the current liabilities from the earlier example:
Current liabilities = $100,000
The current ratio compares current assets to current liabilities. Companies use it to evaluate their ability to meet short-term obligations. In personal terms, it’s like asking: if a large bill showed up unexpectedly, could you pay it with what you have available in the near term?
Corporations ask the same question. The current ratio helps answer it. The formula is:
Using the example above, can you calculate the current ratio?
A current ratio above 1 means the company has more short-term assets than short-term liabilities. A ratio below 1 means the company doesn’t have enough short-term assets to cover its short-term liabilities, which is generally a concern.
Another formula using current assets and current liabilities is net working capital. Instead of a ratio, it gives a dollar amount representing net short-term resources. The formula is:
Using the same numbers as above, can you calculate the net working capital?
Here, the company has $25,000 more in current assets than current liabilities. That amount represents a short-term cushion if an unexpected obligation arises.
The term “quick” refers to short-term finances. Each quick formula in this section measures liquidity. The more liquid a company is, the more cash and marketable assets it has available when an unexpected payment comes due.
First, we’ll look at the quick assets formula:
By subtracting inventory, the company focuses on assets that are typically easier to convert to cash quickly. If the company needs to make a sudden payout, inventory may not help much (unless it can be sold quickly). You can think of quick assets as what the company has “in its wallet.”
There’s also a quick ratio, also known as the acid test ratio. This ratio is one of the best ways to evaluate liquidity because it considers both:
The higher the quick (acid test) ratio, the more liquid the company is. If the ratio is above 1, the company has enough short-term assets (without relying on inventory) to pay its short-term liabilities. If it’s below 1, the company may need to sell inventory to meet short-term obligations.
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. Income statements focus on money coming in and money going out. For example:
| 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, but with many more line items. Analyzing income statements helps you understand how well a company sells its products and services and how it manages its costs.
Like a balance sheet, a corporate income statement is more detailed. Here’s an example:
| 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 show cash inflows and outflows over a period of time. In the example above, the company sold $200,000 of product and ended with $55,000 in net income after paying for inventory, operating expenses, interest, and taxes. The company then paid $20,000 in dividends, leaving $35,000 as retained earnings.
For the exam, focus on recognizing what each line item represents rather than memorizing every detail.
Financial statements don’t always provide much explanation by themselves. For example, if a company reports a sharp increase in cost of goods sold compared with prior periods, you’d want to know why. If additional context is needed, companies provide it 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.
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