Investors use different types of analysis to decide whether a stock is a good investment. Fundamental analysis focuses on the company itself - its products and/or services, business structure, management, and financial condition. This chapter shows you how to gather key financial information by reading two core financial statements: the balance sheet and the income statement.
It’s often easier to understand financial statements if you first think 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 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 basic idea is the same: they list what the company owns and what it owes at a specific point in time. You don’t need to be an accounting expert for the exam, but you do need to be comfortable with the main categories and what they mean. 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 look more closely at a few balance sheet items you’ll want to recognize.
Current assets and liabilities
The word current means short term. Current assets are cash (or items expected to become 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 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 are 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
Fixed assets are long-term tangible (physical) assets the company expects to use for at least one year. These typically include:
Intangible assets
Intangible assets are long-term intangible (non-physical) assets the company expects to use for at least one year. These are forms of intellectual property, including:
Long-term liabilities
Long-term liabilities 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’s 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, the company credits $1 to par value of outstanding stock and $49 to capital in excess of par for each share sold.
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.
A balance sheet ultimately shows net worth, also called stockholder’s equity. Net worth helps you estimate the company’s overall value at that 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, then subtract liabilities from assets. Net worth measures the value of a person or company at a specific moment in time.
Now let’s switch to an income statement. A balance sheet is a snapshot at a point in time, but an income statement summarizes performance over a period of time.
In personal terms, you can think of it like tracking cash inflows and expenses to see whether you had a profit or loss over a period. 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 their results in a similar way, but with many more line items. An income statement helps you evaluate a company’s revenues and expenses - how effectively it sells its products and/or services and how it manages costs.
Here’s an example of a 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 (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. The company then paid $20,000 in dividends to shareholders, 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 what caused it. When extra explanation 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 personal protective equipment (PPE), supplemental liability insurance, and cleaning supplies.
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