There are several ways to analyze a security to decide whether it’s worth investing in. Most approaches fall into two broad categories:
We’ll focus on fundamental analysis in this sub-unit. Fundamental analysis looks at a company’s business and financial condition by reviewing items like revenues, expenses, debt levels, and product and/or service lines.
Publicly traded companies must disclose financial information on a regular schedule. Analysts use these disclosures to gather the data they need. Stockholders also have the right to inspect a company’s books and records, and that right is largely satisfied through these required filings:
10-K annual report
10-Q quarterly report
In these reports, fundamental analysts review financial documents 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.
A balance sheet is often easier to understand if you first think about it in personal terms. You could create a personal balance sheet by listing:
You can then use those totals to calculate your 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. With $275,000 of assets and $210,000 of liabilities, this person has a $65,000 net worth.
Corporate balance sheets are more detailed, but the core idea is the same. You won’t need to be an accounting expert for the exam, but you do need to be comfortable with the basics. Here’s a quick example of a corporate balance sheet:
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
Let’s cover a few specific balance sheet items you’ll want to recognize:
Current assets and liabilities
The term current means short term. Current assets include cash and any item expected to be converted into cash within one year. Typical current assets include:
*Accounts receivable is a general term for money owed to the company by third parties (e.g., customers or clients) within one year.
**Although expenses usually are liabilities, prepaid expenses are assets until they are used up. For example, assume a business pays a contractor $10,000 upfront to paint their building. The $10,000 prepay will show as a current asset until the contractor finishes painting the building.
Current liabilities include bills or payments due within one year. Typical current liabilities include:
*Accounts payable is a general term for money owed by the company to third parties (e.g., contractors) within one year.
**The principal on many long-term corporate loans is payable at the end of the loan. This same structure exists with bonds, which is a specific type of loan we’ll cover later in this material. For example, a 20 year bond would require the issuer to pay interest yearly (typically semi-annually), but the principal isn’t due until 20 years after issuance. Therefore, the bond’s principal would only be considered a current liability 19 years into the bond’s existence (one year until payoff).
Fixed assets
These are long-term tangible (physical) assets expected to be used for at least one year. Typical fixed assets include:
Intangible assets
These are long-term intangible (non-physical) assets expected to be used for at least one year. Intangible assets are forms of intellectual property, including:
Long-term liabilities
These are bills, loans, or payments due in more than one year (sometimes 20-30 years later). These typically include:
*A pension is a retirement plan requiring the employer to pay qualifying retirees (usually those that stay employed 20+ years) a certain amount of money until death.
Stockholder’s equity
Equity means ownership. Stockholder’s equity typically includes:
Common stock has a par (face) value that is mainly used for accounting. Capital in excess of par is the amount investors paid above par value. For example, if an issuer sells $1 par common stock for $50 per share:
Retained earnings are profits the company keeps rather than distributing to stockholders. If a company earns $100,000 and distributes $75,000 to common and preferred stockholders, it credits $25,000 to retained earnings.
*The $25,000 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, which helps estimate a company’s overall value at a point in time. 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, and subtract liabilities from assets. Net worth measures the overall value of a person or company at that point in time.
Now let’s switch to an income statement. A personal income statement is similar to reviewing a bank statement: you track money coming in and money going out over a specific period to see whether you had a profit or a loss. For example:
| Event | Amount |
|---|---|
| Paycheck from job | +$3,000 |
| Groceries | -$100 |
| Utilities | -$200 |
| Credit card | -$700 |
| Mortgage payment | -$1,000 |
| Total | +$1,000 |
This is a simple personal income statement. After these five events, this person has $1,000 of “profits.”
Corporations report the same type of information, just with many more line items. Analyzing income statements shows a company’s revenues and expenses, which helps you evaluate how effectively it sells its products and/or services and 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 (profits) before interest and taxes
**EBT = earnings (profits) before taxes
In this example, the company sold $200,000 of products and ended with $55,000 of net income after paying for inventory (COGS), operating expenses (EBIT), interest, and taxes. It then paid $20,000 in dividends, leaving $35,000 as retained earnings.
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 to prior income statements, you’d want to know the reason. Sometimes the explanation is provided 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 personal protective equipment (PPE), supplemental liability insurance, and cleaning supplies.
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