More than anything else, the Series 66 exam is designed to ensure that professionals

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1 Chapter 1 Economic Factors and Business Information More than anything else, the Series 66 exam is designed to ensure that professionals interacting with the investing public actually know what they re talking about. At the core of that goal is the requirement that securities agents and investment adviser representatives demonstrate an ability to analyze the companies they might potentially recommend as investments, as well as evaluate the broad economic risk factors that could affect those investments. Thus, this first chapter focuses on some of the basic building blocks of financial analysis. Like a doctor who should not prescribe remedies without first diagnosing the internal workings of his or her patient, a financial adviser should not be recommending an investment such as a stock or bond without first x-raying the company that issued it. Both regulators and clients are counting on you to be able to avoid obvious misdiagnoses of a company s potential stability, profitability, and possible risk to an investor. As part of learning the ins and outs of the basic financial analysis of companies, you re also going to learn some important concepts that will also apply to helping your clients plan for their goals. Income Statements and Balance Sheets There is nothing more effective for checking the vital signs of a company than looking at its income statement and balance sheet. These are the equivalent of a patient s medical charts, immediately pointing out any history of trouble or developing problems. All financial advisers should be able to locate, read, and interpret these statements for any company. The Income Statement A company s Income Statement shows revenues a company has generated over a period of time, usually quarterly or annually. Often it will have these revenues broken down into their different sources, especially if a company has different lines of business that operate under one name. The income statement also contains the expenses for the company from that same 3

2 Solomon Exam Prep Series 66 Uniform Combined State Law Examination period. Without this information, no financial adviser would be able to get an accurate picture of a company s financial condition. For example, while a company might report sales of $100 million, knowing that it also spent $200 million during that same period gives us a much deeper understanding of what is actually happening with that company and whether it is a worthy candidate for investment. This calculation, which shows whether a company ultimately generated more sales than it spent, is one of the most important numbers in all of fundamental analysis. When a company actually achieves this positive outcome, it is called a profit. When it spends more than it earned, it is called a loss. While the idea of adding up a company s revenue or sales and subtracting the expenses sounds easy enough, there are actually a few subcategories and an order to the whole calculation that you ll need to know for the exam. The full formula for calculating a company s net profit or loss is as follows (broken down into commonly recognized steps): Step #1: Sales Cost of Goods Sold = Gross Profit In this step, sales is comprised of the revenue that a company earns through its main line of business. Cost of goods sold represents the direct cost of providing whatever goods or services a company offers (raw materials, factory labor, etc.). Step #2: Gross Profit Selling, General, and Administrative Expenses = Operating Income (EBIT) Selling, general, and administrative expenses represents the overhead of running a company, including the salaries of its officers, its marketing costs, and rent for its offices. Step #3: Operating Income Interest Expense = Earnings Before Taxes (EBT) Interest expense represents the costs a company pays associated with borrowing money to finance its operations. 4

3 Economic Factors and Business Information Step #4: Earnings Before Taxes (EBT) Income Tax Expense = Net Profit or Loss Income tax expense represents what a company pays out to the government on its own profits, before any additional funds are passed on to shareholders or owners. The Balance Sheet Just like an Income Statement shows two important categories of information about a company s cash flows (what a company earns and spends), a Balance Sheet shows two categories of information that can be used by financial advisers to assess a company s longterm health. Listed on the Balance Sheet, as the name implies, are the assets (everything from cash to inventory to equipment) a company owns and the liabilities (debts) that a company owes. Similar to an Income Statement as well, a comparison between these two categories (in this case, assets and liabilities) provides us with some new terminology. If a company has more assets than liabilities, this difference is known as owners equity. However, if a company has more debt than it has assets, this deficiency is known as negative owners equity. While an Income Statement shows the company s profits over a period of time, a Balance Sheet shows the financial information at a particular point in time. In other words, it is a snapshot of a company s financial health. ÍÍ Test Note: A balance sheet can show whether a company has the assets needed to expand its business and weather economic storms, or is drowning in debt and may be unable to survive an economic downturn. Cash Flow Statement While it is unlikely the exam will ask, a third type of financial statement has become an increasingly important part of how securities professionals analyze an investment s worthiness. The Cash Flow Statement measures how cash and cash equivalents flow in and out of a company over a period of time. This statement is broken down into three standard categories for easier analysis: cash flow from operations, cash flow from investing, and cash flow from financing (loans). Financial Ratios Now that you know how to take an x-ray of a company s financial situation by looking at its balance sheet and income statement, there are a few measures of health that regulators want you to know and be able to use. These simple formulas give advisers a powerful tool 5

4 Solomon Exam Prep Series 66 Uniform Combined State Law Examination to measure a company s stability as well as create a common point of comparison when measuring various companies investment worthiness. The most important set of measures undoubtedly have to do with determining whether a company is digging itself deeper into debt or experiencing a cash flow crunch. Use of these financial ratios can signify that a company may be one step away from the financial graveyard due to not being able to meet its short-term financial obligations. Naturally, advising clients to invest their money in such a company without being able to read the financial writing on the wall can spell disaster for you, your clients, and your employer. By using three key ratios (the Current Ratio, the Quick Ratio, and the Debt-to-Equity Ratio), an adviser can quickly assess where a company stands compared to itself in previous periods, as well as to established benchmarks. The Current Ratio The Current Ratio is a measure of a company s ability to meet its short-term debt obligations out of its most liquid assets (those easily converted into cash). It draws its name from the fact that the ratio compares what accountants refer to as a company s current assets to its current liabilities (or debts). In its most basic form, the Current Ratio can be written as follows: Current Ratio = Current Assets Current Liabilities A company s current assets are those that can be converted to cash easily within the coming 12-month period without a significant decrease in value. This would naturally include all cash and bank account balances, as well as inventory and short-term receivables. A receivable is a fancy way of saying money owed to the company by someone else, and short-term means that they can expect to collect on it in the next 12 months. A company s current liabilities are the amounts of debt the company will be expected to repay in the next 12 months. So, a better way to understand the Current Ratio is by using the following formula: Current Ratio = Cash + Accounts Receivable + Inventory Debts That Must Be Repaid Within 12 Months Here s an example of how the ABC Company s Current Ratio of 2.0 was calculated based on the following amounts found on its balance sheet: $1,000,000 Cash $5,000,000 Accounts Receivable $10,000,000 Inventory $8,000,000 Short-term Debt (Payable within 12 months) 6

5 Economic Factors and Business Information ABC Co. Current Ratio = $1,000, ,000,000 + $10,000,000 $16,000,0000 = $8,000,000 $8,000,000 = 2.0 ÍÍ Test Note: If the exam asks you about the significance of the Current Ratio, it s pretty straightforward. The ratio measures a company s ability to meet its short-term debt obligations out of its most liquid assets. The larger the overall result, the more likely the company is to be able to meet its debt obligations in the short term. The Quick Ratio Another important measure of a company s ability to stay afloat is the Quick Ratio, which essentially measures the same thing as the Current Ratio above, with one key difference. The Quick Ratio does not include inventory among the assets counted on the top line of the equation. Thus, the formula is: Quick Ratio = Cash + Accounts Receivable Debts That Must Be Repaid Within 12 Months As opposed to the Current Ratio, the Quick Ratio is meant to give an adviser a sense of a company s ability to stay afloat without having to liquidate its inventory (which could be very hard to do without limiting the company s ability to further do business). Naturally, a company with a ton of inventory but not a ton of cash would look less attractive using the Quick Ratio compared to the Current Ratio. Here s an example of how the ABC Company s Quick Ratio of.75 was calculated based on the following amounts found on its balance sheet: $ 1,000,000 Cash $ 5,000,000 Accounts Receivable $10,000,000 Inventory $ 8,000,000 Short-term Debt (Payable within 12 months) ABC Co. Quick Ratio = $1,000, ,000,000 $6,000,000 = $8,000,000 $8,000,000 =.75 Bottom Line: If the exam asks you about how to interpret the Quick Ratio, there are two things you need to know. First, just like the Current Ratio, the higher the number, 7

6 Solomon Exam Prep Series 66 Uniform Combined State Law Examination the better the ratio. Secondly, the closer that the Quick Ratio is to the Current Ratio, the greater a company s true ability to pay all their short-term debts on a moment s notice. Debt-to-Equity Ratio The last of the key ratios that regulators have put in the study guide for the exam is the Debt-to-Equity Ratio. This ratio measures how much money a company has borrowed or owes as part of its operations, compared to how much net worth its owners (the shareholders) have embedded in the company. The formula is similar to comparing how much you owe on your home s mortgage with how much would be left over if you sold your house and paid off the mortgage. In addition to providing a handy form of apples to apples comparison between potential companies an adviser might recommend as an investment, it also can provide some insight into a company s ability to weather financial storms. That s because lenders and vendors that are owed money by a company generally get priority in recovering funds from a struggling company over its shareholders and owners. The higher the debt-to-equity ratio, the greater the likelihood an investor could lose everything if a company goes bankrupt and is forced to liquidate its assets. The formula for the Debt-to-Equity Ratio is: Debt-to-Equity Ratio = Total Liabilities (all money owed) Total Owners Equity Here s an example of how the ABC Company s Debt-to-Equity Ratio of 3.0 was calculated based on the following amounts found on its balance sheet: $ 4,000,000 Short-Term Debt $ 5,000,000 Long-Term Debt $ 3,000,000 Owners Equity ABC Co. Debt-to-Equity Ratio = $4,000, ,000,000 $9,000,000 = $3,000,000 $3,000,000 = 3.0 Other Important Measures and Terms While it s unlikely that your exam will mention the following formulas for measuring a company s health, they have been known to pop up on the exam from time to time. They re mentioned here in the hopes that you ll make a single flashcard for each, memorize the formula for a rainy day, and move on with your life. 8