The basics
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.
We’ll discuss fundamental analysis in this sub-unit, which involves inspecting a company’s business practices and finances by analyzing revenues, expenses, debt levels, and product and/or service lines. Publicly traded companies are required to disclose their financials quarterly, which is where analysts gather this information. Stockholders maintain 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
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.
Balance sheets
Sometimes it’s easier to understand financial documents when we think about them in personal terms. You could create a personal balance sheet if you documented all your assets (things you own) and liabilities (things you owe), which then be used 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 complicated but are fundamentally the same as personal balance sheets. You won’t need to be an accounting expert for the exam, but it’s essential to feel comfortable with the basics. Here’s a quick example of a corporate balance sheet:
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
- Par value of common stock = $5,000
- Capital in excess of par = $245,000
- Retained earnings = $25,000
Let’s cover a few specific balance sheet items to be aware of:
Current assets and liabilities
The term “current” translates to “short term.” Current assets include cash and any item expected to be turned into cash easily within one year. The following are typical current assets on a balance sheet:
- Cash
- Cash equivalents (like a short term bank CD)
- Accounts receivable*
- Inventory
- Prepaid expenses**
*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 paid. 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 any bills or payments due to be paid within one year. The following are typical current liabilities on a balance sheet:
- Accounts payable*
- Wages payable
- Taxes payable
- Interest payable
- Principal payable (within one year only)**
*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 that are expected to be utilized for at least one year, which typically include:
- Real estate
- Land
- Vehicles
- Equipment
- Computer equipment
- Office equipment
- Furniture
Intangible assets
These are long-term intangible (non-physical) assets that are expected to be utilized for at least one year. Intangible assets are various forms of intellectual property, including:
Long-term liabilities
These are bills, loans, or payments due to third parties in more than one year (sometimes 20-30 years later). These typically include:
- Long-term debt securities (bonds and notes > 1 year)
- Mortgages
- Pensions*
*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:
- Par value of outstanding stock
- Capital in excess of par
- Retained earnings
Common stocks maintain par (face) values that are only important for accounting purposes. Capital in excess of par is the amount paid above the par value for an investment. For example, let’s assume an issuer sells $1 par common stock for $50 per share. The stock sale would credit $1 to par value of outstanding stock and $49 to capital in excess of par for every share sold.
Retained earnings represent business profits that are not distributed to stockholders. If a company makes $100,000 of earnings and distributes $75,000 to common and preferred stockholders, they’ll credit $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 provide net worth, also known as stockholder’s equity, which helps determine the overall value of a company. The formula is:
Can you calculate the net worth using the total assets and liabilities above?
It takes a little math, but it’s not a complicated formula. Add up all the assets and liabilities, then find the difference. The net worth of a person or company measures its overall value at that point in time.
Income statements
Let’s switch gears and look at an income statement. Like inspecting a bank statement, a person could calculate their profits or losses over a specific period while inspecting their cash inflows and expenses. 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 five events, this person has $1,000 of “profits.” Corporations compile and disclose their finances similarly, but with many more line items. Analyzing income statements provides data on a company’s revenues and expenses, which helps determine how well a company sells its products and/or services and spends 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 (profits) before interest and taxes
**EBT = earnings (profits) before taxes
In the example above, the company sold $200,000 of products but ended with $55,000 of net income after paying for inventory (COGS), operational expenses (EBIT), interest, and taxes. From there, the company paid $20,000 in dividends to shareholders, leaving them with $35,000 of retained earnings.
Financial statements sometimes do a poor job of providing detailed information. For example, what if a company suddenly reported a sharp increase in the cost of goods sold compared to previous income statements? There could be a legitimate reason for this, like a global pandemic requiring more safety measures, resulting in risings business costs. If providing details is necessary, companies offer 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 personal protective equipment (PPE), supplemental liability insurance, and cleaning supplies.
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