Fundamental analysis is a very different approach. The analysts in your broker-dealer's equity research department rely more on quarterly and annual reports provided by companies.

We recommend the Fundamental Analysis tutorial for those who are new to fundamental analysis, or need a refresher:


Key Financial Statements
Annual and quarterly reports contain two key financial statements:

  1. Balance sheet: It shows assets, or what a company owns, and liabilities, or what it owes. The amount by which assets exceed liabilities is called shareholders' equity. A balance sheet is a snapshot of the company's solvency as of a given date, usually the last date in the fiscal quarter.

  2. Income statement: It shows revenue, or the money coming in, and expenses, or the money going out. The amount by which income exceeds expenses is called earnings. Generally, expenses related to costs of goods sold and to selling, general and administrative purposes are subtracted from revenue first. The result is earnings before interest and taxes (EBIT). Then interest expense is taken out and the result is earnings before taxes (EBT). Then tax expense is taken out and what is left is net profit,which can be distributed to shareholders as dividends or reinvested in the business. An income statement reflects a company's earnings for a period of time - every three months for all U.S.-headquartered companies.

Here's what the top half of a balance sheet - the part that focuses on assets - looks like:


JKL COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(US$ MILLIONS)
YEARS ENDED DECEMBER 31, 2004 AND 2005


2005 2004
ASSETS
Current assets
Cash and cash equivalents 10 12
Accounts receivable 44 49
Inventory1 19 28
Total current assets 73 89
Property, plan and equipment, 600 600
Less accumulated depreciation2 (240) (200)
Net property 360 400
Intangible assets, less amortization 180 200
Total assets 613 689


The astute reader will be looking for footnotes to go with those superscript numbers on the "Inventory" and "Less accumulated depreciation" lines. If that's you, then you might have a future as a fundamental analyst. Nevertheless, you can stop looking - those superscript numbers are for demonstration purposes only. Still, you need to know what could be in those footnotes and why they are crucial to fundamental analysis.

Generally Accepted Accounting Principles
Corporate reporting in the U.S. is based on a set of rules called Generally Accepted Accounting Principles (GAAP), which governs the following:

  1. value of inventories,
  2. depreciation,
  3. revenue recognition timing,
  4. accounting for receivables that cannot be collected, and
  5. value of securities owned by the firm.


Exam Tips and Tricks
Of the 5 factors, the first two will be the most important to those writing the Series 7 exam. Under GAAP, a firm may choose which of several permissible techniques it prefers to treat any of these factors, provided these choices are discussed in the footnotes.



LIFO and FIFO Valuation of Inventory

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