Series 65 Study Guide Navigation

A. Basic Economic Theories

It’s not only the merits of specific investment products that will need to be taken into consideration when an investment adviser is trying to help a client by providing the best investment advice.

Economic factors and not only investment products play a huge role when an investment adviser looks to provide the best advice to their clients.

Primary economic principles

Economic conditions affect companies and by extension, the securities market.

The government can affect the economy through the decisions they make. 

Their overall fiscal policy which includes taxation policies as well as how they spend money plays a key role here. 

For example, if expenditure by a  government equals revenues generated by tax,  the outcome will be a balanced budget.

If expenditure is lower, a surplus has occurred while a deficit happens when expenditure is higher than tax revenues. 

You’ll often hear the term, monetary policy, but what does that mean?

Economic activity is influenced by this policy, which is linked to central bank actions and influences credit available as well as the amount of money in the economy. 

Monetary policy is controlled by the Federal Reserve Board, although they have nothing to do with fiscal policy which is controlled by the President and Congress. 

Important economic schools

Here are some of the economic schools that are covered.

Keynesian economics

This sees government intervention play a critical role. 

For example, as a way to stop recessions, government-run programs would help cut unemployment numbers. 

Also, this policy suggests that taxes are lowered and government spending should be increased.

Supply-side and classical economics

The primary concept here is that consumers benefit from a larger supply of goods and services when governments enforce fewer regulations and taxes are kept as low as possible.

This helps create employment and more demand is created for goods. 

If goods are in excess supply, the prices of those goods will also drop, while the prices of goods in demand will rise.

Monetarist theory

Here, the suggestion is that the money supply is governed by  price levels and economic activity  

If there are too few goods and too few dollars in the economy, inflation results. 

Deflation occurs when the opposite is true.  

In terms of money supply, it’s the Federal Reserve Board that will monitor this and make adjustments where necessary. 

There are three main tools that the Federal Reserve Board will use to monitor and adjust the money supply:

  • Reserve requirement changes: The amount of money that banks will lend out to consumers can be lowered by raising the amount they must leave on deposit at the Federal Reserve Board. Interest rates will rise when credit available diminishes and vice versa.
  • Discount rate changes:  If the discount rate (the rate at which the Federal Reserve Board lends to banks) is higher, borrowing is discouraged and the money supply is reduced and vice versa.  
  • Open-market operations: The Federal Reserve Board can buy and sell U.S. Treasury securities under instruction from the Federal Open Market Committee. The money supply goes up as banks have large reserves when the FOMC purchases from them. When the FOMC sells Treasuries, the opposite occurs. 

The actions of the Federal Reserve Board also affect the federal funds rate.

When lending money to each other, this is what banks charge.  

The fee is only applied to overnight loans of more than $1 million.

It’s an excellent indicator of which direction interest rates are moving in the short term. 

Lastly, there is prime rate.

This is the preferential interest rate on the corporate loans offered by commercial banks. 

Banks can set a prime rate figure themselves, but usually, smaller ones will follow the bigger commercial banks’ lead.  

Prime rates generally drop when the money supply of the Federal Reserve Board is eased and they will rise when the contract money supply. 

Balance of payments

This deals with imports and exports and how nations cooperate with each other.

Balance of payment accounts are used as measuring tools.

One of the things it includes is the foreign payments and obligations that are received over the course of a year and these are known as credits. 

It also includes debits, or payments and liabilities that are paid to foreigners. 

The value of the dollar against other currencies affects the balance of trade.

So a weaker dollar means an increase in exports as U.S. goods are bought with foreign currency while the opposite is true as well for a stronger dollar leading to more imports. 

Buying foreign securities is an excellent way in which investors can protect themselves against a weaker dollar. 

Balance of trade

Balance of trade is the largest component of the balance of payments of a country.  

So it’s comparing imports to exports. 

There are two aspects that are important when it comes to balance of trade: trade deficit and trade surplus.

Top down & bottom up analysis

These analysis methods are used to find excellent opportunities for investment. 

Top down analysis

One way to understand how this works is to think of an upside-down triangle where the two sides are equal in length. 

So it’s broad at the top but gets narrow the further you move down.

Analysis starts at the top using broad measures to study the economy. 

Lower down, as it narrows, you start to analyze things in more detail, for example, overall investment objectives.

And then you look at the companies or securities that will help meet those objectives. 

Bottom up analysis

Here, you don’t flip the triangle around, but instead, start at the bottom and work up. 

This means finding the company that fits the investment objectives, the industry they operate in and then, you reach the overall economy at the top.  

Searching begins with the narrowest indicator and gets broader as it goes on. 

There are many other research indicators that analysts use and we are going to look at more of them now. 

Business cycle

Business cycles can be used as a measure of changes in economic activity, periods where economies grow, stay stagnant, or shrink.

The stages of a business cycle

To work out where an economy is moving, economists look at a range of trends in business activity.

An expansion, for example, will see a huge upturn in the need for goods and services which results in::

  • Inflation rising
  • Overall production increasing

Productions increases lead to:

  • More jobs and lower unemployment rates
  • Inventories dropping
  • Stock markets rising
  • Property values rising
  • GDP increase

A peak’s characteristics are marked by:

  • A decrease in the growth rate of GDP
  • Hiring rates slowing down
  • Consumer spending and business investment slow down 
  • An increase in the inflation rate

When there is a contraction, the following will happen:

  • A rise in bond defaults
  • Rise in bankruptcies
  • Unemployment rates go up
  • Those that do have jobs work fewer hours
  • A significant lowering in consumer spending
  • Home construction slows
  • Business investments drop
  • Stock markets drop
  • A decrease in the rate of inflation
  • Less consumer spending means stock inventories grow
  • A negative growth rate for the GDP

A trough’s characteristics include:

  • A change from negative to positive in the growth rate of the GDP 
  • High employment rates 
  • More overtime for workers
  • Spending on consumer goods and housing goes up
  • Inflation is moderate and might start to drop

Cyclical industries

Cyclical industries are heavily affected by both business cycles and inflation trends.

Typically, these industries produce durable goods and raw materials.

Take for example the automobile industry, heavy machinery manufacturers, and raw material producers.

These are excellent examples of cyclical industries. 

In times of recession, however, the demand for the goods cyclical industries produce decreases. 

They won’t invest in any new capital goods either.

Certain industries, like gold mining, are countercyclical. 

This means when the economy begins to falter, they start to excel. 

Growth industries

During their lifetime, most industries will pass through four distinct phases.

Most industries go through four phases during their lifetime: introduction, growth, maturity, and decline.

For it to reach the growth phase, then when compared to the economy, it will be growing at a rate that’s much faster and there are numerous reasons for this. 

 An excellent example of recent growth industries includes social media, for example. 

Just think of the rise of Facebook and Twitter. 

Generally, however, an industry that is in the growth phases will look to expand further and reinvest the earnings they make into that.

This means they aren’t that great for investors who are wanting to earn income from dividend payouts. 

Defensive industries

During normal business cycles, defensive industries are the least affected

A defensive industry is one that produces nondurable consumer goods which include:

  • Energy
  • Food
  • Pharmaceuticals
  • Tobacco and others

No matter where in the business cycle the industry finds itself, there is always a steady need for these goods from consumers.  

That means stocks from these industries lose less value than others during a recession.

That also means that their value increases less than stocks linked to other industries during an expansion. 

But for investors looking for less risk, buying stocks in a company that’s in a defensive industry makes sense. 

For those that use a sector rotation strategy, moving their investments to a defensive industry makes sense when the business cycle moves towards contraction. 

Inflation and deflation

The impact of inflation and deflation on the economy can be significant and they affect several major economic indicators. 

It’s mostly through the  Consumer Price Index (CPI that inflation is measured. 

General price increases for goods and services are measured by this metric.

If inflation is managed properly, it is not necessarily a bad thing for the economy.

In fact, a mild rise in inflation can help business investments by stimulating them, even if prices slowly increase.  

High inflation isn’t a good thing as it affects the overall buying power of the dollar and this drops significantly resulting in the overall need for goods and services dropping off. 

What causes inflation?

Excessive demand is a major factor that leads to inflation. 

In other words, the supply of goods simply cannot meet consumer demand.

Because of this, prices start to rise.

That’s not the only factor, however.

For example, monetary expansion, which sees the stock of money of a country grow faster than the growth rate, can cause inflation too. 


Deflation isn’t a scenario that plays out very often. 

And it’s not necessarily a good thing, either as deflation sets in during times of terrible recession and is marked by an increase in unemployment.  

What causes deflation?

To start, a significant drop in the demand for goods and services, while they are overstocked too. 

To try and increase demand, prices for these goods and services are lowered significantly.

Another reason is when the economy contracts significantly due to an oversupply of money. 

It’s useful to know how inflation impacts bond yields and prices. 

  • Inflation going up increases interest rates and there is a  drop in bond prices and but yields go up
  • Inflation going down decreases interest rates and there is a rise in bond prices and but yields drop

Gross Domestic Product (GDP)

A country’s total final value of all goods and services produced per annum is its Gross Domestic Product (GDP).

The following make up GDP:

  • Person consumption
  • Government spending
  • Gross private investment
  • Foreign investment
  • Net export total value

However, when imports exceed exports, GDP will be negatively affected.

GDP figures serve as indicators too, for example, if it’s negative, that could be a sign of deflation.

A sign of deflation would be characterized by a negative GDP figure.

Employment indicators

A country’s economic health can be assessed based on several key indicators.

The unemployment rate is one of these and it also has a connection to inflation. 

The following are two indicators linked to employment:

  • Average weekly initial unemployment compensation claims
  • Average work week in manufacturing

These two factors can be used to predict the direction of economic activity.

Consumer Price Index (CPI)

What the CPI shows us is the general level of retail prices and it can indicate changes in the cost of living from one period to another. 

By comparing goods bought from one year to the next, you can identify trends. 

In doing so, CPI looks at prices across a broad range of prices covering goods and services. 

From one measurement period to the next, it measures the rate of change, looking for increases or decreases with CPI figures then published every month. 

This is the most used inflation measuring tool by economists. 

Economic activity barometers

In certain aspects of economic activity, there are several indicators of business cycle phases.

Three categories should be noted:

  • Leading
  • Coincident
  • Lagging

We start with leading indicators.

A recession, as well as a business expansion, will produce these indicators. 

Indicators turn down with a recession, but up with an expansion.

This is used by economists as a tool for predicting economic activity for four to six months ahead.

Here are some leading indicators:

  • Overall money supply
  • Building permits
  • Unemployment insurance claims (average weekly claims)
  • Manufacturing hours (average weekly)
  • New orders for consumer goods as well as nondefense capital goods
  • Supplier delivery index – which highlights the performance of vendors
  • 10-year Treasury bonds and federal funds rates and the interest rate spread between them
  • Stock prices
  • Consumer expectation index

Not all of them move together, however.

When most of them show a positive change, economists interpret this as:

  • An increase in spending
  • An increase in production
  • Higher employment figures

Generally, this means that inflation is going to go up too. 

An economic recession is most likely to occur when a majority of the indicators show a downward trend.

Next, we look at coincident/current indicators

When the business cycle changes, these economic measurements will do so at the same time. 

They include

  • Employment in nonagricultural sectors
  • Personal income (not counting social security)
  • Veteran benefits
  • Welfare payments
  • Production in the industrial sector
  • Trade sales in constant dollars
  • Manufacturing in constant dollars

Our next indicators are lagging indicators.

Around four to six months after the economy begins a new trend, lagging indicators will begin to change and when they do, this confirms the new economic trend. 

There are a number of reasons why they are important. 

Analysts use them to confirm that the change is not a temporary one that could change back.

Lagging indicators include:

  • Unemployment average duration
  • The ratio between personal income and consumer installment credit
  • The ratio of trade inventories and manufacturing to sales made
  • Prime rate average
  • CPI for services changes
  • Industrial and commercial loans that are outstanding (total value)
  • Fluctuations in the index of labor cost per unit of output (in the manufacturing sector)

If you want an easier way of understanding what these indicators do, then consider this:

  • Analysts look at leading indicators to predict where the economy will go
  • Analysts look at coincident indicators to determine the state of the economy at any given time
  • Analysts look at lagging indicators to look where the economy has come from

Interest rates and yield curves

Here we look at yield curves and how they affect interest rates.

Generally, interest rates will reflect inflation expectations.

Federal Reserve Board decisions, however, are linked to short-term rates and how it manages the U.S. monetary policy.

Interest rates

The cost of borrowing money is an interest rate and there are several factors that determine the rate at which the borrower pays the money back. 

These are:

  • Loanable funds’ supply and demand
  • The borrower’s credit quality
  • The time period over which the money has been borrowed

Factors that have nothing to do with the borrower also play a role and include: 

  • Current inflation
  • Expected inflation

The coupon payments on bonds are fixed when a company borrows money by issuing them.

The price of these bonds will fluctuate on the secondary market depending on the movement of the interest rate. 

When it goes down, bond prices rise and vice versa. 

We must mention nominal interest rates.

This relates to the true rate that is paid on borrowed money.

If inflation is expected at some point, interest rates will rise. 

Future bonds will therefore carry a higher interest rate than those currently.

With lower interest, older bond prices will drop too when there is a rise in interest rates. 

This has an impact as investors will then look for an equal rate of return for their investments. 

Analysis of yield curves

We can predict the attitude of investors towards interest rates in the future by analyzing the yield curve. 

This compares long term interest rates and the difference between them and results in a yield curve that’s plotted on a graph.

A slope upwards indicates a normal or positive yield curve and the comparison sees long-term interest rates higher than those of the short-term. 

Several reasons lead to this but always remember that lenders must be compensated for:

  • The money’s time value
  • The money’s reduced buying power because of inflation
  • The long periods leading to an increased risk of default
  • The fact that long-term investments are associated with a loss in liquidity.

Yield curves also show what investors expect in relation to inflation.

This means they want higher rates of return on their investment in situations where inflation rates are higher because their spending power is reduced over time. 

An inverted yield curve sees the slope on the graph move downwards.

This happens when the demand for money is higher but the supply for it is not readily available. 

When comparing short-term interest rates to long-term ones, the policy of the Federal Reserve plays a role. 

Also, the Fed policy will have more of an effect on short-term interest rates when compared to long-term interest rates.

In certain situations, for example, an increase in short-term interest rates, the result could see an inverted yield curve. 

If there is one plotted, the first indication is that interest rates have risen steeply but for the most part, they should fall relatively quickly.

If your short-term and long-term interest rates are the same, you will have a flat yield curve.

The shape of the yield curve will vary based on changes within the economic cycle:

  • An ascending yield curve shows economic expansion and interest rates will usually rise in the future.
  • A flat yield curve indicates interest rates stay the same
  • A descending yield curve can occur when credit is tightened by the Federal Reserve. Interest rates will drop in the future

Yield/Credit spread

An investor already knows that the more risk he or she takes with a bond, the higher the potential return.

Analysts often compare the yields of bonds with the same maturity, but different quality/ratings, in order to gauge the market’s sentiment.

Yield spreads – the difference between Treasury and corporate bond yields – are often used as a measurement in this regard.

In terms of yield spreads, if economic conditions are bad, they will widen and as they improve, they will narrow.

But they can be used in another way.

This occurs when there is one issuer but they have different issues on the market.

Here’s how yield spread can help forecast economic conditions.

If the yield spread widens between corporate bonds compared to their government counterparts, a recession is possible.

Investors generally will then invest in government bonds because they are less risky, although they don’t provide as high yields as corporate bonds. 

The economy is slowing down as a result of this trend.

If the yield spread between government bonds and corporate bonds narrows, an economic expansion is likely.

Investors are now willing to take more risks by buying corporate bonds with higher yields in place of government bonds.

Yields on U.S. Treasury securities are also used by analysts. 

To do this, they start with 91-day T-bills and can then end with a variety of options including 10-year notes or 30-year bonds.

 B. Financial Reporting And How It Works

Here’s how companies go about reporting their financial results.

Financial statements

Financial statements are the best place to start should you be looking for a fundamental analysis of a corporation.

The information they provide covers:

  • Liquidity
  • Financial strength 
  • Profitability
  • Overall operating efficiency

By comparing companies against their competitors using financial statements, analysts can determine how financially viable a company is. 

For those companies that trade publicly, financial reports, which include a balance sheet and income statement, must be sent to the SEC each quarter.

Balance sheet

Let’s look at what information you’ll find on the balance sheet.

Well, it’s a snapshot of how a company is doing at a certain point in time and basically, it shows what the company owns in assets against liabilities.

By finding the difference between these two, the net worth of the company is easily determined. 

The balance sheet equation can be presented in two forms.

  • Assets minus liabilities is equal to owners’ equity and;
  • Assets = liabilities + owners’ equity.

Net worth is important because this overall value for a corporation is the owners’ or shareholders’ equity.


Assets are placed in a specific order on a balance sheet based on how liquid they are.

The first to be listed will be those that are easiest to turn into cash and it will proceed from that point, ending with those that are hardest.  

There are also three asset classes that they are further divided into. 

We have:

  • Current assets (which are easily liquidated)
  • Fixed assets (these include property or those that while they can be sold, cannot be done so quickly)
  • Other assets (those assets that are only valuable to the organization itself)

Let’s cover current assets in some more depth. 

These can be converted to cash easily, for example, in the next year.

They include:

  • Cash and cash equivalents: This can include securities that can be sold quickly and other short-term investments. 
  • Accounts receivable: This is cash and other money received for goods sold or services rendered. 
  • Inventory: Includes products in progress, raw materials owned, as well as those already produced and awaiting sale.
  • Prepaid expenses: Companies often pay in advance for items or services. Listed here are those that have not been received.

The next type is fixed assets.

Equipment or property owned are examples of fixed assets.  

These can be converted into cash when sold, but the process will take some time. 

Fixed assets also need to be maintained and have a lifespan, for example, a company fleet.

As they will depreciate over time, when it comes to taxable income for fixed assets, amounts can be taken off to compensate for this.

This makes up for the losses as a result of depreciation.

Lastly, we look at other assets.

These are related to the specific company and include contract rights, trademarks, or nonphysical properties, as an example. 

They are only really valuable to the company that owns them. 


A balance sheet will reflect two types of liabilities: current liabilities and long-term liabilities.

We begin with current liabilities.

This is any debt that a company has over the next year.

Current liabilities include:

  • Accounts payable: Including business accounts, and accounts with suppliers  
  • Accrued wages payable: This covers all wages, salaries, and commissions
  • Current long-term debt: This is long-term debt that will need to be paid in the next year
  • Notes payable: Covers items that were bought on credit and the balance due on them over the next year. 
  • Accrued taxes: This covers any unpaid local, state, and federal taxes.

Next are long-term liabilities.

This includes bonds or mortgage payments that need to be made over the next year  

Furthermore, it includes outstanding corporate bonds and long-term promissory notes.

Shareholder equity

Shareholder’s equity, owners’ equity, and net worth, it’s all the same thing. 

After all creditors have been paid, the stockholders are entitled to this amount from the company’s assets.

This is made up of three balance sheet components:

  • Capital stock at par
  • Capital in excess of par
  • Retained earnings

We begin with capital stock at par.

This means that it’s at par value that stock will be listed, both common and preferred. 

When we speak about par value, it’s connected to dollar value per share. 

Specifically, it only pertains to the first capital contribution by the corporation’s owners or stockholders.

The par value of a common stock is in no way related to the stock’s market price.

What about capital in excess of par?

This is money received that’s over par value when common stock is issued.

Last is retained earnings.

These are profits earned by a company but not paid to shareholders as dividends.

This will include all earnings held by the company since its formation, but dividends paid to shareholders must be taken off too. 

Due to operating losses incurred in the past, retained earnings for past years are reduced.

Capital structure

A company’s capitalization is obtained by adding its long-term debt and equity securities.

Capital structure is the term used to describe the amount of equity and debt that makes up that capitalization.

In terms of methods of financing themselves, there are numerous ways a company can choose to do this.

This includes borrowing, for example, while others could rather make use of retained earnings. 

The balance sheet of a company whose capital structure is built by debt and equity will include the following four elements:

  • Long-term debt
  • Capital stock (both common and preferred)
  • Capital in excess of par
  • Retained earnings

There are various aspects of capital structure that we should go into more detail about. 

We begin with issuing securities.

Consider a company that has issued 1 million shares.

Common stock is being offered at $5 per share with a par value of $1.

As a result of issuing another million shares, the shareholders’ equity (net worth) will increase.

The amount it goes up will depend on the additional capital raised by this issue of shares.

 On the asset side of the balance sheet, the amount of cash reflected will increase. 

And convertible securities?

Converting convertible debt securities into common stock shares has two effects.

It increases the owner’s equity and reduces his or her liability. 

Next up is bond redemption.

When bonds are redeemed, this is reflected on a balance sheet by liabilities being reduced as debt has been repaid. 

On the assets side, however, there is a change as well, as cash will decrease because it was used to pay the debt, while working capital goes down as well. 

It is due to the fact that a current asset (in this case cash) reduced the long-term liability (bond).

There is a future effect in the retirement of bonds as well. 

Cash flow increases because the debt’s semiannual interest payments are no longer required.

Dividends are critical as well. 

If a cash dividend is declared on stock, two things occur.

First, the current liabilities rise.

Second, the retained earnings drop. 

That cash dividend declaration establishes a current liability on the balance sheet until it is paid.

After this is paid, however, both current liabilities and current assets will be reduced.

We need to look at stock splits.

This cannot have an effect on shareholders’ equity, although the outstanding number of shares on the balance sheet will change as well as their par value. 

Our final aspect is financial leverage.

Financial leverage refers to a company’s ability to increase its return on equity by using long-term debt.

When the long-term debt to equity ratio is high, a company is considered highly leveraged.

Leverage is beneficial to stockholders when the return on borrowed money exceeds the debt service cost.

Leverage has risks too, however. 

That’s due to the fact that an excessive increase in debt could lead to a default during a downturn.

Obviously, for companies that are highly leveraged, changes in interest rates can affect them severely. 

Financial statement footnotes

Financial statements have footnotes and here you will find important management and financial issues highlighted that can have an effect on how a company performs. 

For example, footnotes could include details of the company’s accounting methods, whether there is anticipated litigation in the future as well as long-term debt information.

Footnotes are useful tools.

For example, they can be used to forecast future cash outflows as well as maturity dates, conversion privileges, call provisions, book financing arrangements, and more. 

Income statement

We now move on to the income statement which is also known as the profit and loss (P&L) statement.

It includes the revenue generated by sales during a given period as well as any expenses incurred too.

That time period can be quarterly, a full year, and even year-to-date. 

This provides analysts with insight into revenue coming in versus costs going out over a particular time frame and can be used to evaluate the profitability and efficiency of the company. 

There are various components of an income statement including both non-operating as well as operating costs. 

We begin with revenues, the money that comes into a company over the time the income statements are recorded for. 

The cost of goods sold will also be reflected. 

This tracks costs such as material, production, and labor as well as deprecation that happens as assets the company owns are used during production. 

By taking the cost of goods sold from the revenue generated, you can determine the gross margin.

Divided by net sales/revenues, it is expressed as a percentage.

To get the pretax margin and the net operating profit, take the cost of goods sold from other operating costs, like utilities and rent. 

These figures are earnings before rent and taxes or EBIT.

Interest paid on a corporation’s debts will not be included in operating expenses.

Any income payments will lower taxable income.

And for pretax income, subtract from the operating income the interest payment expenses to calculate it. 

When certain conditions are met, dividends can be paid out to stockholders.

Once this happens, earnings will have the remaining income added.

Once all payments have been carried out, the remaining income can be plowed back into the company as reinvestment if they want to. 


Depreciation has already been discussed earlier when discussing the company’s fixed assets.

This means that their cost is what appears on the balance sheet, but their accumulated depreciation is subtracted.

Depreciation schedules must be followed for tax purposes based on the type of asset.

You should also understand the income statement and how depreciation is reflected on it.

These expenses are accounted for as part of the cost of goods sold as a yearly allowable expense.

When accelerated depreciation is used by the company, costs are far higher in the beginning years of the asset’s life.

Thus, the early years will have a lower pretax income and lower income taxes due to the higher expenses.

As the years pass, the income will increase.

Accounting fundamentals

The Series 65 exam could include some accounting concepts you must know. 

Audited v unaudited statements

Modern bookkeeping allows us to look at the financial position of a company easily. 

Accounting records that are produced in-house or by outside accounting firms are considered unaudited which is perfect for normal business operations. 

Nevertheless, to report to regulators, records must be audited and this is carried out by an independent auditor. 

Cash v accrual

Cash accounting is something used mostly by small businesses, while larger corporations use the accrual method. 

When we compare the two, it’s the timing of the recognition of expenses and revenue that’s the main difference. 

For the cash method, as cash is received, it is recorded.

For accrual, when transactions are said to be booked, that’s when they are recorded.

Cash flow statement

Cash flow statements include both the sources of cash and its uses but also other information. 

In addition, it will include the value of cash and cash equivalents at the start and end of the year. 

Three elements generate cash flow:

  • Financial activities
  • Operating activities
  • Investing activities

Operating activities cash flow

Cash flow from operating activities is the result of various events that produce transactions and include:

  • Cash that is received by the business 
  • Interest, dividends, or other income 

Besides cash payments, there are other factors that contribute to operating activities, such as money that leaves the company.

Included in this are:

  • Inventory cost
  • Payroll costs
  • Taxes
  • Interest payments
  • Rent payments
  • Payment of utilities

The amount of net cash provided and used by operating activities is an important figure on cash flow statements.

Investing activities cash flow

Investing includes buying/selling buildings, land, securities, and other assets and as a product of the business, these aren’t going to be sold in the future. 

The making of loans and the collection of them must be added to this as well. 

Investment activities will never be considered as operating activities.

This is because most companies are in the business of selling goods or providing services.

This is indirectly associated with the business’s investing activities.

Financing activities cash flow

Financing activities are what you’d expect them to be – the flow of cash between different parties. 

It’s broken down into equity and debt financing.

Debt financing is straightforward and it’s the money that involves creditors.

Equity financing is the flow of cash from the owners of the business.

Financing activities include issuing stock and generating cash proceeds but also include repurchasing stock as treasury stock, paying dividends, or retiring bonds. 

On the Series 65 exam, you should remember that when we talk about cash flow from operations, we are referring to income statement items.

The clash flow generated from financing activities are balance sheet items.  

Forms used for SEC reporting

The reports that companies have to file with the regulators provide some excellent financial information about them and are readily available on the SEC website. 

Three forms in particular are extremely useful for fundamental analysis. 

Form 8-K

This includes newsworthy events that must be reported to the SEC.

This includes a management change, name change, bankruptcy, mergers, acquisitions, and more. 

The company had four days to file this form once the event has occurred.

Form 10-K

This form is used when filing an annual report with the SEC.

Annual reports contain audited statements and show the overall financial position of the company. 

This is not the same report that shareholders will receive, however. Many people think this report is the same one sent to the shareholders.

The annual report accompanying a Form 10-K goes into far more detail.

Form 10-Q

Over the course of a year, a lot can happen for a company, so it’s important to file the Form 10-Q once a quarter.

It is applicable to companies that have a float of less than $75 million, and the accompanying documents are unaudited financial statements.

The SEC must receive three reports each year within 40 days after the end of a fiscal quarter.

Since the 10-K is filed in the fourth quarter, there is no need to file a Form 10-Q.

Annual reports

In most cases, shareholders of a publicly-traded company will receive an annual report.

Next to information found about a company on the SEC website, the annual report is the next best set of financials to find out more about them, especially over the last fiscal year. 

Annual reports also operate as marketing tools with messages from the CEO and Chairman of the Board, for example. 

They will also include shareholders voting proxies if needed as well as details about new products or services.  

 C. Analytical methods 

There are a number of analytical methods available to us when it comes to making better investment decisions.

Money and its time value  

When you look into potential targets that are companies to invest in, you have to understand the numbers.

Our earlier discussion looked at how financial statements can be used to assess a company. 

But now we are going to look at the quantitative analyst’s tool that can be used too. 

These are used as a way in which they can get the assistance they need.  

Before we start, understanding the time value of money is critical.  

To begin, we look at the present value of a future sum.

Take this into consideration.

Consider the case of an investor who is promised a specific amount of money 10 years from now. How will that compare to having the money today?

Therefore, instead of waiting, the investor can use the funds over the next decade.

The present value of $38.55 equates to $100 in 10 years if they earn 10% of the money, which is compounded annually.

We also need to understand another concept related to time value.

That’s calculating how much money needs to be invested now by using an assumed rate of return so that in the future, a defined amount can be reached.

The name of this computation is future value.

Based on the example we used above, if an investor deposited $38.55 now and 10% interest was earned (compounded annually), in 10 years they would have $100 

Future value

Let’s look a little deeper into future value or FV.

We know that it shows that at a certain given rate, what an amount that is invested will be worth at a certain time in the future. 

The future rate of invested dollars made today will depend on these elements: 

  • Earned rate of return (r)
  • The time  over which it will be invested (in years)  (n)

He’s the equation to calculate future value:: FV = PV x (1+r)n.

Present value

Present value refers to the investment’s future cash flow value at this moment. 

The present value of that future cash flow is worked out by discounting a specific interest rate to that.

The following formula is to work out PV = FV / (1+r)n.

Rule of 72

Based on compound earnings, the Rule of 72 determines how long it takes for an investment’s value to double.

To do this, divide 72 by the interest rate of the investment.

If you invest $2,000 and earn 6%, it will take 12 years for your investment to double.

How do we know that? 

This is easy to work out as you take 72  divide by 6 and 12 is your answer. 

Rule of 72 can also work backwards as well.

By knowing the number of years, you can calculate the earnings rate to double by.

In this case, 72 is the numerator while the denominator is the number of years.

Net present value (NPV)

NPV analyzes the present value of an investment and its cost.

NPV is the difference between these two.

Here is an example.

Take a positive NPV of $10.

This means that if an investment costs $100, then it has a discounted PV of $110.

Here the NPV of $10 is the difference between the PV of the investment’s future returns (or $110 and the cost of $100)

In our example, if the PV is less than $100, let’s say $90, then the NPV is negative.

In this case, it’s a negative NPV of $10.

This is because, when compared to the present value, the price is higher than it. 

NPV is always expressed as a dollar amount.

Internal rate of return (IRR)

When an investment’s NPV is made equal to zero, that’s due to the discount rate (r) which is known as the IRR.

(r) is one of the elements of PV and FV calculations.

IRR is difficult to calculate directly.

Instead, a process called interaction is used, which is largely a trial and error process.

With IRR, the time value of money is also taken into account.

Although it can be used for pretty much any investment, it can only be applied to companies that pay a stable dividend when it comes to common stock.

Calculating IRRs helps an investment adviser determine if an investment is going to generate the kind of return an investor wants.

Remember these key things about NPV and IRR for the exam:

  •  IRR can be used to work out long-term returns when taking the time value of money into consideration.
  • The yield to maturity of a bond indicates its IRR
  • A good investment will have a positive NPV.
  • In general, NPV is considered more important than IRR.  

Central tendency measures

In this section, we are going to look at some numerical tools used for analysis and with these, time value does not play a role. 

A method an investment adviser can use to determine the logical outcome of a security investment is through central tendency. 

When we define central tendency, it has to do with the center of the distribution.

There are many ways to measure it. 

Mean/Arithmetic mean

When it comes to analyzing the world of securities, analysts use many different measures.

When they measure central tendency, the most common method is by mean/arithmetic mean. 

But what is this exactly?

Well, all it does is work out an average and it does so by looking at the sum of the variables and dividing by the number of occurrences. 

For example, how would you work out the mean of a stock that’s produced the following dividends: 9%, 8%, 5%, and then 2%

Add them up and divide the sum by the number of occurrences according to the equation, which gives you a mean of 6%.


The median is the midpoint of a distribution.

Variables can be found both above and below the median.

So then how can you find the median if you have data showing a number of returns? 

Let’s list them in order first with this example: 11, 4, 13, 8, 7.

Starting from lowest to highest that would be: 4, 7, 8, 11, and 13.

Here, 8 is considered the median. 

When the number of variables is even, you take the average of the middle two numbers in other words. 

When a distribution is skewed, it is often better to use the median instead of the mean.

When variables are found outside of the normal range. Always use the median instead of the mean.


To work out mode takes some math skills and because of this, it’s highly unlikely to appear on the exam. 

Just try to understand more or less how it works. 


When we talk about range in a sample, we’re talking about the difference between the highest and lowest returns.

However, results can be skewed in a particular direction.

This occurs when there are more values at either end of the range and so, mid-ranges values are the ones looked at more often than not. 

Here’s an example of what we mean using the numbers from earlier: 4,7, 8, 11, and 13.

The range is calculated by taking the lowest number (4) from the highest (13) which equals 9. 

Beta coefficient

Beta coefficient is another measurement that’s used often. 

It compares the movement of the market as a whole with that of a stock or portfolio.

Basically, it’s a measure of the variance between the two.

A stock with a beta of 1.00 has a similar risk to the market as a whole.

Beta measurement is done through Standard and Poor’s 500 composite index.

Stocks with a beta over 1.50 are considered to be riskier and more volatile than one with a beta of 0.70, for example.

Some stocks can have a negative beta and these are often used to help diversify a portfolio.

That’s because the stock market drops, it is then that they show positive returns. 

Clients who favor aggressive investments will look for stocks with betas over 1.00, while those who favor conservative investments will seek out stocks with low positive betas.

As the S&P 500 rises and falls, the beta of a stock will rise and fall too, and here’s how that plays out.

A stock’s beta goes up by 1 when the stock rises by 10% and falls by 1 when the stock falls by 10%.


A portfolio manager will always consider generating a positive alpha to be good news. 

This means that the portfolio has performed above expectations and takes both risk and the overall volatility of the investments made, into account. 

If this is the case, the portfolio manager has excelled in terms of the selection of securities and the timing of them as well. 

Questions on the exam might be about how much alpha was produced for either a single stock or perhaps an investment portfolio with the risk taken into account. 

Well, you need to remember that alpha can be positive or negative but it can also be zero. 

A negative alpha means the portfolio is not performing well. 

When positive, however, the portfolio is doing better than the market. 

When alpha is zero, the portfolio is not better or worse off than the market currently. 

Here’s the equation for alpha: Alpha = (total returns on the portfolio – risk-free rate) – portfolio beta x [market return – risk-free rate])

Standard deviation

Using historical performance data, standard deviation is another form of measurement that looks at the projected returns of an investment and measures the volatility linked to it. 

This is accomplished by measuring the dispersion around an average, and what we really mean when we refer to dispersion is variability.

The bigger the dispersion, the higher the standard deviation.  

By the same token, the returns on the security in question should deviate from that average return.

This also means greater risk. 

Here’s how standard deviation can be used to predict price volatility.

Consider these details below for common stock returns over a three-year period for two companies.

  • Company ABC: 2016 – 8% returns, 2017 – 12% returns, 2018 – 10% returns
  • Company DEF: 2016 – -4% returns, 2017 – 25% returns, 2018 – 9% returns

The average investment on returns for Company ABC was 10%.

For Company DEF, it’s the same figure at 10%.

When it comes to the greater dispersion of the mean, which share would you choose?

Well from the returns alone, it would be DEF. 

For clients with a more risk-free approach, ABC provides an investment option when the standard deviation is lower. 

It’s as a percentage that standard deviation is expressed

Two-thirds of the time, it is generally accepted that securities will vary within one standard deviation.

It will vary within two standard deviations around 95% of the time.

Let’s look at an example with a stock that has an 8.5 standard deviation.

For any given period, there is a possibility of a return variance of 8.5%, either above or below the predicted return.

It happens about two-thirds of the time, and within 15% around 95% of the time.

Correlation coefficient

Two securities moving in the same direction are in correlation. 

In the case of one’s price rising by 5% and the other one’s does as well, they are in perfect correlation. 

Correlation is also related when prices fall.

Let’s move on to the correlation coefficient. 

The value for this ranges from -1 to +1.

The securities would be perfectly correlated if the value was +1.

Securities with unrelated price movements have a value of 0.

If they are moving in perfectly opposite directions, the value would be -1 and they are now negatively correlated. 

Generally, securities with correlations more than 0.80 are considered to have high correlations.

In the world of securities, how does all this work?

Let’s examine index funds. 

The goal is to mirror an index such as the Standard and Poor’s 500.

Correlation-wise, they aim for +1 or perfect correlation.

In order to achieve this, the fund manager will try to improve the performance of the underlying index.

Ratios: Balance Sheets

Earlier, we covered the balance sheet as well as the income statement and the ways in which they can be used as analysis tools.

We will cover calculations that can be obtained from these documents.

We start with those linked to working capital.

Working capital is a company’s liquid capital or cash that they have on hand.

It’s an excellent way to judge their overall liquidity and ability to turn assets into cash quickly. 

The formula for working capital is:

  • Working capital = current assets – current liabilities

The following factors will increase working capital:

  • Issuing long-term debt or equity securities to increase cash
  • Profits from business operations result in an increase in cash
  • The sale of nonconcurrent assets increases cash. 

As current liabilities increase, working capital will decrease, including:

  • Declaration of cash dividends 
  • Long-term debt payments  
  • Net operating losses

Next, we explore current ratio.

Working capital is a valuable tool, but when paired with current ratio, it’s simply a better way to measure a company’s strength.

The computation is similar with current liabilities and current assets used.

Now, however, they are expressed as a ratio to calculate the current ratio.

You do this by dividing the current assets by the current liabilities of the company.

The higher the ratio, the more liquid the company is.

We also need to talk about quick asset ratio or acid ratio test.

It is critical that a company is able to meet all of its short-term obligations.

To determine this in the quick asset ratio, analysts can use a more stringent test than those we have looked at.

The measurement here is not current assets but quick assets. 

When inventory is taken away from current assets, what remains is called quick assets.

To work out the quick ratio, divide the quick assets by the current liabilities.

There’s another calculation you can carry out as well.

Divide the current assets by the current liabilities after removing any inventory.

Another computation from balance sheet information is the debt-to-equity ratio.

To calculate the amount of financial leverage a company is using, the debt-to-equity ratio is an excellent tool to do so. 

As an example of a capitalization table for a company, consider the following:

  • Long-term debt: $50 million
  • Preferred stock: $20 million
  • Common stock: $1 million
  • Capital surplus: $4 million
  • Retained earnings: $15 million
  • Total equity capital: $40 million
  • Total capitalization (equity + long-term debt): $90 million

The total capital used by the business is $90 million while $50 accounts for long-term debt.

To work out the debt-to-equity ratio as a percentage, divide the total capital by the total long-term debt.

In this case, it’s $90/$50 which gives a debt-to-equity ratio of almost 56%.

Our last computation is book value per share.

Book per value gives the corporation a liquidation value.  

This is in terms of all assets being disposed of, all debts being paid and stockholders being paid.

In the calculation of book value per share, only tangible assets will be included.

These must be subtracted from total assets to determine the tangible asset amount.

Here’s the formula for book value per share:

Book value per share = tangible assets – liabilities – preferred stock par value / shares of common stock outstanding.

Ratios: Income statement

We can calculate a number of useful ratios from the income statement.

Let’s start with earnings per share (EPS).

It measures the value of the company earnings for each common share.

The equation is as follows:

  • Earnings available to common / outstanding number of shares = EPS.

Therefore, when we discuss earnings available to common stockholders, we are only speaking about the value after the preferred dividend has been paid.

Therefore, EPS only relates to common stock.

Preferred stockholders are not entitled to any earnings in addition to their dividends.

Next, we have earnings per share after dilution.

This is associated with convertible securities and it’s assumed that they have all been converted to common stock. 

As a result, EPS is reduced because more common stock now participates in earnings.

Our next calculation based on the income statement is current/dividend yield.

Its current yield is determined by the annual dividend payout expressed as a percentage of the current stock price.

Here’s the equation:

  • Annual dividends per common share / market value per common share = current yield.

Last, it’s dividend payout ratio.

Dividends are involved here and this measures the proportion of earnings that are paid to stockholders.

Here’s the equation for it:

  • Annual dividends per common share / earnings per share (PS) = dividend payout ratio

Companies that have been around for a long time have tended to pay out larger percentages of earnings as dividends,

Since they reinvest their earnings in the business, growth companies have the lowest ratios.

Stockholders are rewarded in other cases with gains in stock instead of high dividends.

It is especially true for companies that are on the rise.

Market price related ratios

Price-per-earnings ratio (P/E).is one that’s widely used by analysts. 

Here the relationship between two elements is taken into account and these are different common stock prices compared with accrued earnings to one share of stock.

The equation or P/E ratio is:

  • Current market price of common share / earnings per share (EPS) = P/E ratio

You can calculate EPS once you know the P/E as well as the market price of the stock:

  • Current market price of a common stock / P/E ratio = EPS

In the scenario of a $45 stock price and 20 times more than the earnings, you would work out the EPS by dividing 45 by 20 which gives $2.25 per share.

The price-to-sales ratio is viewed as a better analytical tool by fundamental analysts than the price-to-earnings ratio.

It is because different accounting methods can affect earnings more than sales.

Next, we look at price-to-book ratio.

This ratio expresses the market price of a common stock relative to its book value.

The book value is expressed as a dollar value per share.

A company provides it to shareholders as a measure of value in the event of a liquidation, but it has little or no relationship with the stock’s current value.

D. Investment Risk Types

There are risks that can impact both a business and investors.

Here we examine the different types of investment risks that investors should be aware of.

Risks are divided into systematic and unsystematic risks. 

Systematic risks

Investing in risky assets can be adversely affected by macroeconomic factors which are considered as systematic risks. 

These risks can affect the individual securities of a company no matter how well it’s performing overall.  

There are numerous types of systematic risks including:

  • Market risk
  • Interest rate risk
  • Purchasing power risk
  • As well as others

Market risk

Almost all securities lose value when the market loses value.

No matter the number of different stocks a portfolio might comprise, a stock market crash will see a decline for most, if not all of them and this is a classic example of non-diversifiable risk.

It can be protected somewhat by ensuring a portfolio includes some negatively correlated securities.

When others go down, they will go up as we saw in the previous section.

When it comes to measuring the market risk of a security, you would use its beta.

Interest rate risk

There is no doubt that interest rates fluctuate and the market will be affected due to this.

As interest rates increase, bond market prices will be affected, for example. 

Bond market values also fall when interest rates rise and therefore, interest rate risk is considered to be systematic.

What is the effect of diversifying an investment portfolio on reducing interest rate risk?

Well, it doesn’t help that much. 

That’s because when interest rates rise, the price of all bonds will fall.

Interest rate risk applies to all fixed-income investments, from preferred stock to debt securities, the issuer has no effect on this at all. 

What can play a role is term to maturity.

In other words, the further an investment is from maturity, the larger the price fluctuations can be. 

In addition, it’s worth noting that credit quality won’t affect interest rate risk because all bonds are affected by the rise or fall of interest rates. 

Reinvestment risk

A variation of interest rate risk is reinvestment risk.

This is connected to the principal, however. 

A periodic cash flow might be provided by an investment.

A debt security that pays interest is an example of this.

Depending on the rate of interest paid by the security, they may not be able to reinvest this income to receive similar returns.

For example, let’s say an investor purchased a bond with an initial 10% coupon on purchase. 

Years later similar securities are paying 7%.

It’s therefore difficult for the investor to compound the investment near the original rate.

Zero-coupon bonds, however, don’t have this problem because there is nothing to reinvest from them. 

At maturity, reinvestment risk can be a problem too. 

For example, a fixed-income investor receives a 10% return on a bond.

When it matures, however, the only option for reinvestment is a security with a 7% return, so reinvestment risk is in action in this scenario.

Inflation risk

This is also called purchasing power risk.

The higher the inflation rate, the less purchasing power a currency has.

Inflation is not something that cannot exist in an economy, however, but when it spirals out of control, problems arise. 

In terms of securities, it causes investor uncertainty and it makes evaluating potential returns of current or future investments extremely difficult. 

Luckily, some investments are designed in such a way that they can provide a form of protection against inflation risk.

This includes Treasury inflation protected securities, for example 

Others, however, are extremely vulnerable when inflation starts to rise, and fixed-income securities would be an excellent example of this. 

Are there securities that are not vulnerable to the rise of inflation?

Well, equity securities would fall into that category.

Others that provide a hedge against inflation included real estate, for example.  

Unsystematic risks 

Unsystematic risks have one significant area of difference from systematic risks.

They can be protected against through portfolio diversification.

These risks are often related to a specific industry or type of business too. 

Here’s some examples of the types of unsystematic risks you should know about. 

Business risk

We start with business risk.

An example of this would be operating risks that put the business in danger. 

A poor management decision is the perfect example of business risk.

Business risks can sink companies with stockholders losing everything they have invested, so it is something that’s not to be taken too lightly. 

Even if the worst-case scenario doesn’t play out, if a business risk hits a company an investor has shares in, they will probably see their earnings potential lowered because of it.

For investors that only look to invest in one issuer, business risk is a real factor.

Financial risk

Don’t confuse financial risk with business risk, even though they are similar.

It is specifically speaking about debt financing (leverage) and how companies utilize it.

Defaulting on debt obligations can lead to a variety of consequences, but bankruptcy is the worst.

An investor in that company will likely lose everything they invested in it if that happens.

Credit risk

This is also known as default risk. 

An investor who has placed money in debt securities may be impacted.

Should that be the case, it could mean that payments of the principal, interest, or sometimes both, aren’t paid out by the debtor. 

For equity investors, credit risk is a subcategory of financial risk. 

Stockholders who invest in a highly leveraged company do run the risk of losing their money when that company fails to meet its debt obligations. 

As a result, they might declare bankruptcy, and in that case, their equity securities may be completely lost.

There are securities that don’t come with credit risk, common stock for example is one of these. 

Regulatory risk

Changes in regulatory climate can affect not only businesses but all industry sectors as well.

Changes in regulations can pose a regulatory risk, but so can various court judgments.

Regulations made by the Environmental Protection Agency, for example, often affect the oil and gas industry.

Airlines, pharmaceutical companies, and other green industries could also be affected by regulatory risk.

Legislative risk

There is a tendency to group legislative and regulatory risks together, but they are not the same.

 Consider this:

  • Regulatory risk is associated with a change in regulations
  • Legislative risk is associated with the change of laws

Sometimes, this can be seen as a political risk, especially when motivated by a particular political agenda. 

Tax code changes are an excellent example of a legislative risk.

Legislators are the only ones with the power to pass a law, while state or federal agencies can pass regulations.

Perhaps one of the best examples of legislative risk came in the 1990s when the government implemented a luxury tax on yachts.

This almost destroyed the boat-building industry completely. 

Political risk

As an example of political risk, take a country where political stability is not assured.

This could present a real concern for those looking to invest in emerging economies.

It’s not only limited to those, however, as a change of leadership in an established country could lead to political risk as well. 

Sovereign risk

Sovereign risk is associated with a country defaulting on its commercial debt obligations.

As an example, Greece has had numerous problems paying its debts, but this can happen to any country.

Country risk is a subcategory of sovereign risk.

A country’s economic and political stability is evaluated here.

Political and sovereign risks are a combination in this respect. 

Liquidity risk

Basically, liquidity risk is how quickly an investment can be converted into cash.

Additionally, there’s another condition related to this, namely that the process shouldn’t disrupt the market price.

There are times when an investor wants to sell an investment but cannot, due to current market conditions, or no one wants to buy the stock.

This describes liquidity risk perfectly. 

Another example of liquidity risk is real estate.

You don’t just sell a home overnight, do you?  

So what securities are best to fight liquidity risk?

Which sells easily?

Well, Treasury bills are an example but so are listed stocks and mutual funds.  

Currency/Exchange rate risk

Forensic currencies will fluctuate just like domestic currencies

This will affect investors that have purchased them, either through ADRs or directly. 

One way to avoid this is by purchasing only domestic securities.  

Opportunity cost

Opportunity cost refers to the return given up on an alternative investment, also known as forgone return. 

Let us look at this from a more economic point of view.

Opportunity cost refers to the highest value alternative that must be given up by the investor to select another alternative investment.

We can easily explain this with a short-term Treasury bill as they don’t incur much risk at all. 

With almost no effort on the part of the investor, he or she can benefit from this risk-free alternative to other securities.

Any deviation from a risk-free return represents an opportunity gained or lost.

Liquidation priority

Capital structure refers to how a company raises capital.

Common stock forms the main foundation of this.

Occasionally, they may also issue preferred stock, but not all corporations do so.

Additionally, debt securities are issued in order to employ leverage, which entails borrowing money.

An issuer may issue securities with collateral, such as a mortgage bond, or on general credit; like a debenture. 

All of these methods are used by some corporations.

That’s why investors should know the order of liquidation priority for the corporation they’ve invested in.

Here’s how that order runs:

  • Secured creditors.  
  • Unsecured creditors
  • Subordinated debt holders
  • Preferred stockholders
  • Common stockholders

An investor who owns common stock is last in line to get their money back if a corporation goes bankrupt.

Debt securities, such as a subordinated debenture, for example, will always be preferred over equity securities as far as payment of principal and interest is concerned.

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