Two companies can report identical net income while one is running short of cash and the other sits on a deep cushion. The financial statements show which is which, and the exam asks you to do the arithmetic.
Fundamental analysis means judging a company's stocks and bonds by studying its business and its financial statements. You use it to explain why a bond looks safe or a stock looks expensive, and to match an issuer to a customer's objective. Bondholders care about debt and interest coverage. Income-seeking stockholders care about dividends and the earnings behind them.
A public company files its annual report with the Securities and Exchange Commission (SEC) on Form 10-K. Regulation S-X, the SEC's rule set for financial statements, sets the core annual report contents. Rule 3-01(a) requires audited balance sheets for the two most recent fiscal years. Rule 3-02(a) requires audited income and cash flow statements for the three most recent years. A smaller reporting company files two years under Rule 8-02.
Common mistakes
- Reporting working capital as a ratio. Lakeshore's working capital is $1,500,000, and 2:1 is its current ratio. When the answer choices mix dollars and ratios, match the units first.
- Leaving preferred in book value per share. Subtracting only intangibles gives ($3,500,000 − $1,000,000) ÷ 400,000 = $6.25 instead of $3.75.
- Using net income for bond interest coverage. $900,000 ÷ $300,000 = 3 times understates safety, because interest is paid before taxes. Use EBIT to get 5 times.
Bottom line
- The 10-K has audited balance sheets for two years and income and cash flow statements for three, and its notes disclose liens, defaults, dividend restrictions and the inventory method.
- Assets equal liabilities plus shareholders' equity, and capitalization is long-term debt plus equity.
- Depreciation, depletion and amortization are noncash charges, and goodwill is tested for impairment, not amortized.
- With rising prices, LIFO gives higher COGS, lower earnings and taxes, and a lower ending inventory.
Exam shortcut
Before you calculate, find the denominator the stem is really asking for. Coverage uses EBIT, not net income. Book value per share and EPS both strip out preferred. Yield and payout need an annual dividend, so multiply a quarterly figure by 4. For transaction questions (pay a bill, buy inventory, sell bonds), write current assets and current liabilities before and after, then recompute.
The full lesson (about 4,607 words, 31 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- C12
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