The basics
There are several ways to analyze a security to decide whether itâs worth investing in. Most approaches fall into two broad categories:
⢠Fundamental analysis
⢠Technical analysis
Weâll focus on fundamental analysis in this sub-unit. Fundamental analysis looks at a companyâs 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 companyâs books and records, and that right is largely satisfied through these required filings:
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 review financial documents to estimate a companyâs 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
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:
⢠Assets (things you own)
⢠Liabilities (things you owe)
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 wonât need to be an accounting expert for the exam, but you do need to be comfortable with the basics. Hereâs 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 & shareholderâs 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
Stockholderâs equity = $275,000
⢠Par value of common stock = $5,000
⢠Capital in excess of par = $245,000
⢠Retained earnings = $25,000
Letâs cover a few specific balance sheet items youâll 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:
⢠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 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*
⢠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 weâll 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 isnât due until 20 years after issuance. Therefore, the bondâs principal would only be considered a current liability 19 years into the bondâs 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:
⢠Real estate
⢠Land
⢠Vehicles
⢠Equipment
⢠Computer equipment
⢠Office equipment
⢠Furniture
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:
⢠Trademarks
⢠Patents
⢠Copyrights
⢠Trade secrets
Long-term liabilities
These are bills, loans, or payments due 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.
Stockholderâs equity
Equity means ownership. Stockholderâs equity typically includes:
⢠Par value of outstanding stock
⢠Capital in excess of par
⢠Retained earnings
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:
⢠$1 is credited to par value of outstanding stock
⢠$49 is credited to capital in excess of par
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 stockholderâs equity, which helps estimate a companyâs overall value at a point in time. The formula is:
Net worth = assets - liabilities
Can you calculate the net worth using the total assets and liabilities above?
Net worth = assets - liabilities
Net worth = $525,000 - $250,000
Net worth = $275,000
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.
Income statements
Now letâs 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 âprofits.â
Corporations report the same type of information, just with many more line items. Analyzing income statements shows a companyâs 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. Hereâs 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 donât 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, youâd 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.
Key points
Fundamental analysis
⢠Inspection of a companyâs finances
10-K annual report
⢠Audited financial report
10-Q quarterly report
⢠Unaudited financial report
Balance sheet
⢠Compares company assets and liabilities
⢠Indicates a companyâs 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
