Reading Balance Sheets & Income Statements
📌 The page opens by noting: this chapter mostly reviews material from the fundamental analysis chapter. There is some new content here, but you can treat most of it as a refresher.
Fundamental vs. technical analysis
- There are various ways an investor can analyze a security to decide whether it’s worth investing in. Broadly, analysis falls into two main categories: fundamental analysis and technical analysis.
- 🔑 Fundamental analysis is a traditional approach that focuses on a company’s business and financial condition — revenues, expenses, debt levels, and product and/or service lines. Publicly traded companies must disclose financial information quarterly, and analysts use those disclosures to evaluate the company.
- Stockholders have the right to inspect a company’s books and records. In practice, that right is largely satisfied through required financial disclosures.
Required financial disclosures
| Disclosure | What it is | Example given |
|---|---|---|
| 10-K annual report | Audited financial report | Tesla 10-K filing |
| 10-Q quarterly report | Unaudited financial report | Microsoft 10-Q filing |
10-K = annual = audited. 10-Q = quarterly = unaudited.
Statements analysts review
| Statement | What it shows | Key relationship |
|---|---|---|
| Balance sheet | Compares assets and liabilities | Assets − liabilities = net worth |
| Income (cash flow) statement | Displays income and expenses | Money coming in vs. money going out |
⚠️ There are differences between income statements and cash flow statements, but the exam generally doesn’t test those details. For exam purposes, you can treat them as providing similar information about money coming in and going out.
Sidenote: Auditor disclosures
- Financial disclosure forms like Form 10-K must be audited by an independent third party (typically an accounting firm). The auditor’s job is to review the issuer’s financial statements and determine whether they are complete and accurate.
🔑 The auditor must include these disclosures on the forms they audit:
| # | Required auditor disclosure |
|---|---|
| 1 | The issuer is responsible for providing the financial statements and data |
| 2 | The auditor is responsible for providing an opinion on the supplied financial data |
| 3 | The auditing standard used by the auditor |
| 4 | The auditor’s opinion on the financial data |
- Auditing standards set the methods and requirements used when an audit is performed. A common standard is Generally Accepted Auditing Standards (GAAS).
- The most important part of the auditor’s disclosures is the opinion.
Unqualified vs. qualified opinions
| Opinion | Definition | Example / meaning |
|---|---|---|
| Unqualified opinion | Best-case scenario — the auditor believes the financial statements fairly and accurately reflect the issuer’s financial situation | Tesla 10-K: “In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of [Tesla, Inc.]…” |
| Qualified opinion | Issued if the auditor believes the statements are misleading or omit a material item. A “qualifier” is an added message that limits or weakens the original message | Plain-English analogy from the text — Unqualified: “I am good at studying.” Qualified: “I am good at studying, but only if I don’t have access to video games.” |
- There are several possible reasons for a qualified opinion — for example, misrepresented financials, an asset or liability not properly reflected, or improper accounting methods.
- ⚠️ Regardless of the cause, a qualified opinion reflects poorly on the issuer and is typically a major concern for shareholders.
Balance sheets
It’s often easier to understand financial statements by translating them into personal terms. You could create a personal balance sheet by listing your assets (things you own) and liabilities (things you owe). The difference is your net worth.
Personal balance sheet example
| Assets | Liabilities | Net worth |
|---|---|---|
| $250k home | $200k mortgage | |
| $20k car | $10k car loan | |
| $5k cash | ||
| $275k | $210k | $65k |
This person has $275,000 of assets and $210,000 of liabilities, leaving $65,000 of net worth.
Companies track assets and liabilities in the same basic way (just with many more categories and line items). You don’t need to be an accounting expert for the exam, but you should be comfortable with the structure of a corporate balance sheet.
Simplified corporate balance sheet
Assets
| Category | Line item | Amount |
|---|---|---|
| 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 | |
| Total assets | $525,000 |
Liabilities & shareholder’s equity
| Category | Line item | Amount |
|---|---|---|
| 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 | |
| Total liabilities | $250,000 | |
| Stockholder’s equity = $275,000 | Preferred stock | $80,000 |
| Common stock | $150,000 | |
| Capital in excess of par | $25,000 | |
| Retained earnings | $20,000 |
Balance sheet items to recognize — definitions
| Term | Definition | Example |
|---|---|---|
| Current | “Current” means short term (generally within one year) | Anything due or convertible within 12 months |
| Current assets | Assets that are already cash or can reasonably be converted to cash within a year | Cash, cash equivalents (like a money market fund), accounts receivable (money owed to the company within one year), and inventory |
| Current liabilities | Liabilities due now or that must be paid within a year. They often include items with the word “payable.” “Payable” means the company owes a payment in the near term | Accounts payable, wages payable, taxes payable, interest payable |
| Fixed assets | Long-term tangible assets | Real estate, property, vehicles, and equipment |
| Intangible assets | Long-term non-physical assets | Trademarks, patents, copyrights, and other intellectual property |
| Long-term liabilities | Obligations that extend beyond one year | Longer-term loans, bonds, and mortgages |
| Stockholder’s equity | Equity represents ownership. Commonly includes outstanding stock, capital in excess of par, and retained earnings | Preferred stock, common stock, capital in excess of par, retained earnings |
| Capital in excess of par | The amount investors pay above a security’s par value | If an issuer sells $100 par preferred stock for $102 per share, $2 per share is credited to capital in excess of par |
| Retained earnings | Earnings the company keeps rather than distributing to stockholders | If a company earns $100,000 and distributes $80,000 to common and preferred stockholders, it credits $20,000 to retained earnings |
Note from the text: the $20,000 of retained earnings in this example would be added to any unspent retained earnings accumulated over previous years.
Balance sheet formulas
Balance sheets ultimately show net worth, also called stockholder’s equity.
🔑 Net worth
Net worth = assets − liabilities
Worked example from the page (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, then subtract liabilities from assets.
Several common formulas use current assets and current liabilities to measure a company’s liquidity (its ability to access cash to meet short-term obligations).
Current assets and current liabilities (recap)
- Current assets typically include cash, cash equivalents (like money markets), accounts receivable, and inventory. Accounts receivable are payments the company expects to receive soon for goods or services already provided. In other words, if the company has cash — or something that can reasonably be turned into cash soon — it’s usually a current asset.
- Current assets = $125,000 → Cash and cash equivalents $100,000; Accounts receivable $15,000; Inventory $10,000
- Current liabilities typically include accounts payable, wages payable, taxes payable, and interest payable. These are short-term bills the company must pay, such as costs of goods, operating costs (general business costs), interest on outstanding loans (including bonds), and taxes. If it must be paid within a year, it’s generally a current liability.
- Current liabilities = $100,000 → Accounts payable $40,000; Wages payable $30,000; Taxes payable $20,000; Interest payable $10,000
🔑 Current ratio
The current ratio compares current assets to current liabilities. Companies use it to gauge their ability to meet short-term obligations. A personal analogy helps: the current ratio is like asking whether you could cover a large unexpected bill using the resources you can access in the near term.
Current ratio = current assets ÷ current liabilities
⚠️ Reconstructed fraction. The page’s text extraction flattens fractions and prints the denominator first: it renders as “Current ratio=current liabilitiescurrent assets”. The correct orientation is current assets over current liabilities, verified against the page’s own worked numbers ($125,000 ÷ $100,000 = 1.25, not $100,000 ÷ $125,000 = 0.8).
Worked example from the page:
Current ratio = current assets ÷ current liabilities Current ratio = $125,000 ÷ $100,000 Current ratio = 1.25
- If the current ratio is above 1, the company has more short-term assets than short-term liabilities.
- ⚠️ If it’s below 1, the company doesn’t have enough short-term assets to cover its short-term liabilities, which is generally a warning sign.
🔑 Net working capital (NWC)
Another common measure is net working capital. Instead of a ratio, it gives a dollar amount of net short-term resources.
NWC = current assets − current liabilities
Worked example from the page:
NWC = current assets − current liabilities NWC = $125,000 − $100,000 NWC = $25,000
Here, the company has $25,000 more in current assets than current liabilities. That cushion can help if an unexpected short-term obligation comes up.
🔑 Quick assets (QA)
The term “quick” refers to short-term finances. These formulas focus on liquidity — how much cash and near-cash the company has available. Liquidity matters because short-term obligations often need to be paid quickly.
QA = current assets − inventory
This removes inventory and focuses on cash and other marketable assets. If the company needs to make a sudden payment, inventory may not be helpful unless it can be sold quickly.
🔑 Quick ratio (acid test ratio)
Next is the quick ratio, also called the acid test ratio. This is a common way to evaluate liquidity because it compares quick assets to current liabilities.
QR = (current assets − inventory) ÷ current liabilities
⚠️ Reconstructed fraction. The page renders this as “QR=current liabilitiescurrent assets - inventory” (denominator printed first). The correct orientation is (current assets − inventory) over current liabilities — the numerator is the quick assets figure defined immediately above, and the text confirms it “compares quick assets to current liabilities.” Sanity check with the page’s numbers: ($125,000 − $10,000) ÷ $100,000 = 1.15, i.e. above 1.
- A higher quick (acid test) ratio indicates greater liquidity.
- If the ratio is above 1, the company can cover current liabilities using short-term assets without relying on inventory.
- ⚠️ If it’s below 1, the company may need to sell inventory to meet short-term obligations.
Balance sheet formula summary
| Formula | Expression | What it measures |
|---|---|---|
| Net worth | Assets − liabilities | Overall value of company or person |
| Current ratio | Current assets ÷ current liabilities | Ability to pay short-term obligations |
| Net working capital | Current assets − current liabilities | Liquid cash and marketable assets on hand |
| Quick assets | Current assets − inventory | Near-cash resources excluding inventory |
| Quick (acid test) ratio | (Current assets − inventory) ÷ current liabilities | Company’s liquidity |
Income statements
If you’ve ever looked at your bank account activity, you’ve seen a personal version of one: money comes in, money goes out.
Personal income statement example
| Event | Amount |
|---|---|
| Paycheck from job | $3,000 |
| Groceries | -$100 |
| Mortgage payment | -$1,500 |
| Total | +$1,400 |
After these three events, this person has $1,400 of positive cash flow.
Companies report income and expenses in a similar way, just with many more line items. Analyzing income statements helps you understand how well a company generates revenue and controls costs.
🔑 Simplified corporate income statement
| 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 before interest & taxes
- *EBT = earnings before taxes
🔑 The income statement relationships, stated as formulas:
Sales revenue − COGS = Gross profit Gross profit − operating expenses = Income from operations (EBIT) EBIT − interest = Income before taxes (EBT) EBT − taxes = Net income Net income − dividends paid = Retained earnings
This statement shows the company earned $200,000 in sales revenue and ended with $55,000 in net income after paying for inventory (COGS), operating expenses, interest, and taxes. Then it paid $20,000 in dividends, leaving $35,000 as retained earnings.
As with the balance sheet, the exam focus is usually on recognizing what the major line items represent, not memorizing every possible subcategory.
Footnotes
Financial statements don’t always explain why a number changed. For example, if a company reports a sharp increase in cost of goods sold compared with prior periods, you’d want context. Companies provide that kind of explanation 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 additional personal protective equipment (PPE), additional liability insurance, and cleaning supplies.
Sidenote: Cash vs. accrual accounting
Companies generally use one of two methods to account for revenues and expenses.
| Method | Definition | Example |
|---|---|---|
| Cash-based accounting | Revenues and expenses are recorded when cash actually changes hands | The cost of paying for ice cream cones is recorded when the cones are paid for |
| Accrual-based accounting | Revenues and expenses are recorded when they are created, even if cash payment happens later | The cost of paying for ice cream cones is recorded when the order is placed, even if payment won’t occur for several weeks |
- Although it can be difficult (especially for large organizations with complex structures), a company can switch from one method to another at any point.
Key points
Fundamental analysis
- Inspection of a company’s finances
Balance sheet
- Compares company assets and liabilities
- Indicates a company’s 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
10-K annual report
- Audited financial report
10-Q quarterly report
- Unaudited financial report
Current assets
- Assets able to be converted into cash within one year
Current liabilities
- Liabilities owed now or will be within one year
Current ratio
- 🔑 CR = current assets ÷ current liabilities ⚠️ (reconstructed from the page’s flattened rendering “CR=current liabilitiescurrent assets”)
- Measures ability to pay short-term obligations
Net working capital
- 🔑 NWC = current assets − current liabilities
- Determines liquid cash and marketable assets on hand
Quick assets
- 🔑 QA = current assets − inventory
Quick ratio
- Also known as the acid test ratio
- 🔑 QR = (current assets − inventory) ÷ current liabilities ⚠️ (reconstructed from the page’s flattened rendering “QR=current liabilitiescurrent assets - inventory”)
- Used to determine a company’s liquidity
Cash-based accounting
- Companies account for revenues and expenses when a cash flow occurs
Accrual-based accounting
- Companies account for revenues and expenses when they are created (even pre-cash flow)
Sources
Primary/official references for the material in this chapter. Every link was fetched and returned HTTP 200 on 2026-08-15.
| # | Source | Publisher |
|---|---|---|
| 1 | Beginners’ guide to financial statements — balance sheet, income statement | SEC |
| 2 | How to read a 10-K — the annual report sections | SEC |
| 3 | EDGAR — 10-K/10-Q/8-K filings search | SEC |
| 4 | Achievable Series 65 — chapter 3.2 | Achievable (course text) |