Financial Reporting & Analysis

The Balance Sheet

The balance sheet, also called the statement of financial position, provides a snapshot of a company's financial condition at a specific point in time. It reports what the company owns (assets), what it owes (liabilities), and the residual interest of the owners (shareholders' equity). The fundamental accounting equation that governs the balance sheet is:

Assets = Liabilities + Shareholders' Equity

This equation must always balance. If a company has $10 million in total assets and $6 million in total liabilities, shareholders' equity must be $4 million. Understanding the balance sheet is essential for investment adviser representatives because it reveals a company's financial health, liquidity, leverage, and net worth.

Assets

Assets represent economic resources controlled by the company that are expected to provide future benefits. They are divided into two major categories:

• Current Assets: Assets expected to be converted to cash or consumed within one year (or the normal operating cycle). These include cash and cash equivalents, marketable securities, accounts receivable (money owed by customers), inventory (goods available for sale), and prepaid expenses. Current assets are listed in order of liquidity, with the most liquid (cash) listed first.
• Non-Current (Long-Term) Assets: Assets not expected to be converted to cash within one year. These include property, plant, and equipment (PP&E), intangible assets (patents, trademarks, goodwill), long-term investments, and deferred tax assets. PP&E is reported net of accumulated depreciation, which reduces the asset's book value over time to reflect wear and usage.

Liabilities

Liabilities represent obligations the company owes to creditors and others. Like assets, they are classified by time horizon:

• Current Liabilities: Obligations due within one year, including accounts payable (money owed to suppliers), short-term debt, accrued expenses (wages, taxes, interest owed but not yet paid), current portion of long-term debt, and unearned revenue (payments received for goods or services not yet delivered).
• Non-Current (Long-Term) Liabilities: Obligations due beyond one year, including long-term debt (bonds payable, bank loans), deferred tax liabilities, pension obligations, and long-term lease obligations.

Shareholders' Equity

Shareholders' equity represents the owners' residual claim on the company's assets after all liabilities have been satisfied. Key components include:

• Common Stock (Par Value): The nominal or par value of issued common shares. Par value is an arbitrary amount (often $0.01 or $1.00) with little economic significance.
• Additional Paid-In Capital (APIC): The amount received from shareholders in excess of par value. If a company issues stock with $1 par value at $50 per share, the APIC per share is $49.
• Retained Earnings: Cumulative net income that has been reinvested in the business rather than distributed as dividends. Retained earnings = Beginning retained earnings + Net income - Dividends paid.
• Treasury Stock: Shares that the company has repurchased and holds in its treasury. Treasury stock is reported as a contra-equity account (reduces total equity) because it represents shares no longer outstanding.

The Income Statement

The income statement (also called the profit and loss statement or P&L) reports a company's financial performance over a specific period, typically a quarter or a year. Unlike the balance sheet, which is a snapshot, the income statement covers a flow of activity. It follows a hierarchical structure from revenue down to net income, with each level providing insight into different aspects of profitability.

Revenue (Top Line)

Revenue (also called sales or the "top line") represents the total amount of money a company earns from selling its goods or services before any expenses are deducted. Revenue recognition rules under Generally Accepted Accounting Principles (GAAP) require that revenue be recognized when earned and realizable, regardless of when cash is received. Analysts distinguish between organic revenue growth (from existing operations) and growth from acquisitions.

Cost of Goods Sold (COGS)

COGS represents the direct costs attributable to the production of goods or services sold by the company. For a manufacturer, this includes raw materials, direct labor, and manufacturing overhead. For a retailer, it is the purchase cost of inventory sold. Revenue minus COGS equals gross profit, and the gross profit margin (gross profit / revenue) indicates how efficiently a company produces its goods.

Operating Expenses and Operating Income

Operating expenses include costs not directly tied to production but necessary for running the business: selling, general, and administrative expenses (SG&A), research and development (R&D), and depreciation and amortization. Subtracting operating expenses from gross profit yields operating income (also called EBIT, earnings before interest and taxes). Operating income reflects the profitability of the company's core business operations, excluding the effects of financing decisions and taxes.

Net Income (Bottom Line)

From operating income, interest expense (cost of debt financing) and income taxes are subtracted to arrive at net income, the "bottom line." Net income represents the profit available to common shareholders. It is the figure that flows into retained earnings on the balance sheet. Companies report net income on both a total and per-share basis.

Earnings Per Share (EPS)

Earnings Per Share (EPS) is one of the most widely followed financial metrics. It divides net income available to common shareholders by the weighted average number of common shares outstanding:

EPS = (Net Income − Preferred Dividends) ÷ Weighted Average Common Shares Outstanding

Companies report two versions of EPS: basic EPS (using shares actually outstanding) and diluted EPS (assuming all convertible securities, stock options, and warrants are exercised). Diluted EPS is always equal to or lower than basic EPS and provides a more conservative view of per-share profitability.

The Cash Flow Statement

The statement of cash flows tracks the actual movement of cash into and out of a company during a specific period. While the income statement can be influenced by accounting choices (revenue recognition, depreciation methods, accruals), the cash flow statement provides a more objective view of a company's financial health because cash is much harder to manipulate. The statement is divided into three sections based on the source of cash flows.

Operating Cash Flow (CFO)

Cash flow from operations represents cash generated (or consumed) by the company's core business activities. It starts with net income and adjusts for non-cash items (depreciation, amortization, stock-based compensation) and changes in working capital (changes in accounts receivable, inventory, accounts payable). Healthy companies consistently generate positive operating cash flow. If a company reports positive net income but negative operating cash flow, it may be a warning sign of earnings quality issues.

Investing Cash Flow (CFI)

Cash flow from investing captures cash spent on or received from long-term investments. Common items include capital expenditures (purchases of PP&E), acquisitions of other businesses, purchases and sales of investment securities, and proceeds from asset sales. Growing companies typically have negative investing cash flow because they are spending money on capital expenditures to expand operations. Free cash flow (FCF), defined as operating cash flow minus capital expenditures, measures the cash available for debt repayment, dividends, buybacks, or further investment.

Financing Cash Flow (CFF)

Cash flow from financing records transactions between the company and its providers of capital. This includes proceeds from issuing stock or bonds, repayment of debt, dividend payments to shareholders, and stock buyback expenditures. A company that is paying down debt and buying back shares will have negative financing cash flow, while one that is issuing new equity or borrowing will have positive financing cash flow.

Financial Ratios

Financial ratios allow analysts and advisers to evaluate a company's financial performance and compare it to peers and historical averages. The Series 65 tests several categories of ratios. Understanding both the formulas and their interpretations is essential.

Liquidity Ratios

Liquidity ratios measure a company's ability to meet short-term obligations:

• Current Ratio = Current Assets ÷ Current Liabilities. A ratio above 1.0 means the company has more current assets than current liabilities, indicating it can likely meet its short-term obligations. A ratio significantly below 1.0 may signal liquidity problems. However, a very high current ratio could indicate inefficient use of assets.
• Quick Ratio (Acid Test) = (Current Assets − Inventory) ÷ Current Liabilities. This is a stricter measure because it excludes inventory, which may not be quickly convertible to cash. Industries with slow-moving inventory (manufacturing, retail) may show a significant difference between current and quick ratios.

Leverage (Solvency) Ratios

• Debt-to-Equity Ratio = Total Debt ÷ Total Shareholders' Equity. This measures the proportion of debt financing relative to equity financing. A higher ratio indicates greater financial leverage, which amplifies both returns and risk. Utilities and real estate companies typically have higher debt-to-equity ratios than technology companies.
• Interest Coverage Ratio = EBIT ÷ Interest Expense. Measures how easily a company can pay interest on its outstanding debt. A ratio below 1.5 may indicate difficulty servicing debt, while ratios above 5.0 suggest comfortable coverage.

Profitability Ratios

• Return on Equity (ROE) = Net Income ÷ Average Shareholders' Equity. Measures the return generated on shareholders' investment. Higher ROE generally indicates more efficient use of equity capital. However, high ROE can result from high leverage rather than operational excellence.
• Return on Assets (ROA) = Net Income ÷ Average Total Assets. Measures how efficiently a company uses its total assets to generate profit. ROA is particularly useful for comparing companies with different capital structures because it is not affected by leverage.

Valuation Ratios

• Price-to-Earnings (P/E) Ratio = Market Price per Share ÷ Earnings per Share. The most widely used valuation metric. A high P/E may indicate that investors expect high future growth, or that the stock is overvalued. A low P/E may indicate undervaluation or expected earnings decline. Trailing P/E uses past earnings; forward P/E uses estimated future earnings.
• Price-to-Book (P/B) Ratio = Market Price per Share ÷ Book Value per Share. Compares market valuation to accounting value. A P/B below 1.0 means the stock trades below book value. Financial and asset-heavy companies often have lower P/B ratios.
• Dividend Yield = Annual Dividends per Share ÷ Market Price per Share. Measures the income return on a stock investment. Utility stocks and REITs typically have higher dividend yields. Growth companies often pay little or no dividends.

Fundamental Analysis vs. Technical Analysis

Investment professionals use two primary approaches to analyzing securities: fundamental analysis and technical analysis. While investment advisers overwhelmingly rely on fundamental analysis, the Series 65 tests your understanding of both approaches and their theoretical underpinnings.

Fundamental Analysis

Fundamental analysis evaluates a security's intrinsic value by examining economic, financial, and qualitative factors. The goal is to determine whether a security is overvalued, undervalued, or fairly priced relative to its intrinsic value. Fundamental analysts study:

• Macroeconomic factors: GDP growth, interest rates, inflation, monetary policy, and industry conditions that affect the business environment.
• Industry analysis: Competitive dynamics, barriers to entry, regulatory environment, and growth prospects of the specific industry.
• Company-specific factors: Financial statements, management quality, competitive advantages (economic moats), product pipeline, and strategic positioning.
• Valuation: Comparing intrinsic value estimates (derived from discounted cash flow models, comparable company analysis, or asset-based approaches) to the current market price.

The fundamental approach follows a top-down or bottom-up methodology. Top-down analysis starts with the economy, narrows to promising sectors, and then identifies specific companies. Bottom-up analysis starts with individual company research, regardless of macroeconomic conditions, focusing on companies with strong fundamentals and attractive valuations.

Technical Analysis

Technical analysis studies historical price and volume data to identify patterns and trends that may predict future price movements. Technical analysts (also called chartists) believe that all relevant information is already reflected in the stock price and that price patterns tend to repeat. Key concepts include support and resistance levels, moving averages, and volume analysis. Technical analysis is covered in greater depth in Chapter 3.

Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis, developed by economist Eugene Fama in the 1960s, proposes that security prices fully reflect all available information, making it impossible to consistently achieve returns in excess of average market returns on a risk-adjusted basis. The EMH has profound implications for investment management because if markets are truly efficient, active management (stock picking and market timing) cannot consistently outperform a passive index strategy after accounting for costs.

Three Forms of Market Efficiency

Fama identified three levels of market efficiency, each incorporating a progressively broader set of information:

1. Weak Form Efficiency: Stock prices fully reflect all historical price and volume data. If the weak form holds, technical analysis is useless because past trading patterns provide no information about future prices. The weak form is consistent with the random walk theory, which holds that stock price changes are random and unpredictable. However, fundamental analysis may still add value because non-public and fundamental information is not yet reflected in prices.
2. Semi-Strong Form Efficiency: Stock prices fully reflect all publicly available information, including financial statements, news reports, analyst reports, and economic data. If the semi-strong form holds, both technical and fundamental analysis are useless because prices instantaneously adjust to new public information. Only investors with material nonpublic (insider) information could achieve excess returns, which would be illegal.
3. Strong Form Efficiency: Stock prices fully reflect ALL information, both public and private (insider information). If the strong form holds, no one — not even company insiders — can consistently achieve excess returns. Most academics and practitioners reject the strong form because insider trading cases demonstrate that insiders can and do profit from material nonpublic information.