R22 Financial Statement Analysis IFT Notes

Financial Statement
Analysis: An
Introduction
2014 Level I Financial Reporting and Analysis
IFT Notes for the CFA® exam

Financial Statement Analysis: An Introduction Irfanullah.co
Contents
1. Introduction ....................................................................................................................................... 3
2. Scope of Financial Statement Analysis ........................................................................................... 3
3. Major Financial Statements and Other Information Sources......................................................... 4
4. Financial Statement Analysis Framework .................................................................................... 11
Summary ............................................................................................................................................. 13
Next Steps ........................................................................................................................................... 15
This document should be read in conjunction with the corresponding reading in the 2014 Level I
CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or
quality of the products or services offered by Irfanullah Financial Training. CFA Institute,
CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute.
Copyright © Irfanullah Financial Training. All rights reserved. Page 2

1. Introduction
Financial analysis is the process of examining a company’s performance in the context of its
industry and economic environment in order to arrive at a decision or environment. For this
purpose, financial reports are one of the most important sources of information available to a
financial analyst. Furthermore, the analyst also uses information contained in the notes to
financial statements and supplementary information (such as management discussion). It is
important that an analyst have a strong understanding of each of these sources of information.
2. Scope of Financial Statement Analysis
In order to develop a basic understanding of financial analysis, we first need to understand the
difference between the roles of financial reporting and financial statement analysis. The role of
financial reporting is to provide information about a company’s performance (Income
Statement), financial position (Balance Sheet) and changes in financial position (Statement of
Changes in Equity).
The role of financial statement analysis is to use these financial reports prepared by companies,
combined with other information, to evaluate the past, current and potential future performance
and financial position of a company for the purpose of making investment, credit, and other
economic decisions. Examples of such decisions include:
 Should an equity investment be included in a portfolio?
 Should credit be extended to a particular customer?
 What is the future net income and cash flow for a particular company?
The performance of a company can include an assessment of a company’s profitability, ability to

generate positive cash flows, liquidity and solvency. Liquidity refers to the ability of a company
to meet short-term obligations. Solvency refers to the ability of a company to meet long-term
obligations.

3. Major Financial Statements and Other Information Sources
Companies prepare financial reports at regular intervals (annually, semiannually, and/or

quarterly depending on regulatory requirements). These financial reports consist of financial
statements and supplementary disclosures and notes. The financial statements summarize
financial information for users outside the company such as investors, creditors and analysts.
3.1 Financial Statements and Supplementary Information
A complete set of financial statements include:

(i) Balance sheet
(ii) Income statement
(iii) Statement of changes in equity
(iv) Cash flow statement
These are discussed in detail in the following section. Along with these required financial
statements, a company typically provides additional information in its financial reports. This can
include a letter from the management discussing results (called management discussion &
analysis [MD&A]), an external auditor’s report providing assurances, a corporate responsibility
report and so on. We now discuss each financial statement and some of the additional
information included in financial reports.
3.1.1 Balance Sheet
The balance sheet (also known as the statement of financial position or statement of financial
condition) presents a company’s current financial position by showing details of the company’s
assets, liabilities and owner’s equity at a specific point in time. Assets are the resources the
company controls while liabilities are the company’s obligations to lenders and other creditors.
Owner’s equity represents the excess of assets over liabilities. It is the owner’s residual interest
in (i.e. residual claim on) the company’s assets after deducting its liabilities.

The relationship between these three parts of a balance sheet can be expressed in the following
equation (sometimes known as the accounting equation): Assets = Liabilities + Owner’s Equity.
An example of a balance sheet is shown below:
Assets Liabilities
Current assets Current liabilities
Cash $200,000 Accounts payables $75,000
Short-term
investments 80,000 Salaries payable 20,000
Accounts
receivable 50,000 Interest payable 20,000
Inventories 350,000 Taxes payable 6,000
Prepaid Current portion of
insurance 20,000 $700,000 note 35,000 $156,000
Long-term
investments Long-term liabilities
Stock
investments $50,000 Notes payable $100,000
Cash value of
insurance 20,000 70000 Bank loan 35,000
Mortgage obligations 60,000
Property,
plant &
equipment Deferred income taxes 74,000 $269,000
Land $50,000 Total liabilities $425,000
Buildings and
equipment $100,000
Less: Accum.
Depreciation -75,000 $25,000 75000
Intangible
assets
Goodwill 275,000 Stockholder's equity
Capital stock $450,000
Other assets Retained earnings 270,000
Receivable
from Total stockholder's
employee 25,000 equity $720,000
Total liabilities &
Total assets $1,145,000 equity $1,145,000
On the left hand side, we see that the assets of the company have been listed. These include both
tangible and intangible assets. On the right hand side, the liabilities and owner’s equity have

been listed. The sum of both sides must be equal, as indicated by the accounting equation. The
balance sheet is always made at a specific point in time, such as on 31 December 2012.
3.1.2 Statement of Comprehensive Income
The statement of comprehensive income can be presented, under IFRS, as a single statement of
comprehensive income or as two statements, an income statement and a statement of
comprehensive income.
3.1.2.1 Income Statement
The income statement presents information on the financial results of a company’s business
activities over a period of time. It is also known as the statement of operations and profit and
loss (P&L) statement.
The income statement shows how much revenue and other income a company generated during a
period and the expenses it incurred to generate that revenue and other income. Revenue refers to
amounts charged for the delivery of goods or services in the ordinary activities of a business.
Expenses include cost of sales, administrative expenses, and income tax expenses. An example
of an income statement is shown below:
Revenues
Net Sales $650,000
Expenses and Losses

Cost of goods sold 200,000
Selling expenses 150,000
General & administrative 165,000
Loss on sale of land 2,100
Interest expense 6,000 523,100
Income Before Tax $126,900
Income tax expense 12,000
Net Income $114,900

Net income (also called net profit) on the income statement is often referred to as the ‘bottom
line’ and can be calculated by using the following equation: Net income = Revenues + Other
income – Expenses = Income – Expenses.
Companies also present basic and diluted earnings per share on their income statement.
Earnings per share (EPS) numbers represent net income attributable to a class of shareholders
divided by the relevant number of shares of stock outstanding during the period. Basic EPS is
calculated using the weighted average number of common (ordinary) shares outstanding. Diluted
EPS is calculated using the number of diluted shares – the number of shares that would
hypothetically be outstanding if potential claims on shares (such as stock options and convertible
bonds) were exercised.
3.1.2.2 Other Comprehensive Income
Comprehensive income includes all items that impact owners’ equity but are not the result of
transactions with shareowners. Under IFRS, when comprehensive income is presented in two
statements, the statement of comprehensive income begins with the profit or loss from the
income statement and then presents the components of other comprehensive income. Examples
of these components are exchange differences on translating foreign operations, deferred taxes,
and gains on available-for-sale financial assets.
3.1.3 Statement of Changes in Equity
The statement of changes in equity reports changes in the owners’ investment in the business
over time. The basic components of owners’ equity are paid-in capital and retained earnings.
Retained earnings include the cumulative amount of the company’s profits that have been
retained in the company. In addition, minority interests and reserves (for accumulated other
comprehensive income items) are shown in equity.
3.1.4 Cash Flow Statement
The cash flow statement discloses the uses and sources of cash for a company over a period of
time. This helps creditors, investors and other statement users evaluate the company’s liquidity,

solvency and financial flexibility. Financial flexibility is the ability of the company to react and
adapt to financial adversities and opportunities.
The cash flow statement organizes the cash flows of the company in three categories: operating,
investing and financing. Cash flows from operating activities generally involve the cash effects
of transactions that are used to determine net income and hence, comprise the day-to-day
activities of the company. Cash flows from investing activities are cash flows from those
activities associated with the acquisition and disposal of long-term assets, such as property and
equipment. Cash flows from financing activities are cash flows from activities related to
obtaining or repaying capital to be used in the business. An example of a cash flow statement is
shown below:
Cash flows from operating activities:
Net income $2,000,000
Add (deduct) noncash effects on operating income
Depreciation expense $100,000
Gain on sale of land -170,000
Increase in accounts receivable -200,000
Decrease in inventory 35,000
Increase in accounts payable 70,000
Decrease in wages payable -20,000 ($185,000)
Net cash provided by operating activities $1,815,000
Cash flows from investing activities:

Sale of land $850,000
Purchase of equipment -200,000
Net cash provided by investing activities $650,000
Cash flows from financing activities:

Proceeds from issuing stock $80,000
Dividends on common -45,000
Repayment of long-term loans -950,000
Net Cash provided by financing activities ($915,000)
Net increase in cash $1,550,000
Cash balance at January 1 100,000

Cash balance at December 31 $1,650,000

The sum of the net cash flows from operating, investing and financing activities equals the net
change in cash during the fiscal year.
3.1.5 Financial Notes and Supplementary Schedules
The notes (also called footnotes) that accompany the four financial statements are required and
are an important part of the complete set of financial statements. They disclose information about
the accounting policies, methods, and estimates used to prepare the financial statements. Both
IFRS and US GAAP allow some flexibility in choosing among alternative policies and methods
when accounting for certain items. This will be discussed in detail in the next reading. Examples
of financial notes and supplementary schedules that the company discloses in its financial
statements include:
 Acquisitions and Disposals
 Commitments and Contingencies
 Legal Proceedings
 Employee Stock Options and Other Benefits
 Related Party Transactions
 Significant Customers
 Business and Geographic Segments
3.1.6 Management Commentary or Management Discussion and Analysis
Companies typically include a section in their annual reports where the management discusses a
variety of issues such as the nature of the business, past results and future outlook. This section
comprises of subjective information where management is presenting its view and interpretation
of that data that it has reported. The management should establish and put in processes to ensure
that the financial reports adequately reflect the economic reality of the company. This section is
known as management commentary or management discussion and analysis (MD&A). Various
regulators in different countries specify what should be included in the MD&A. Examples of
content include trends and significant events affecting the company’s operations, liquidity and
capital resources, off-balance sheet obligations and planned capital expenditures.

3.1.7 Auditor’s Report
A company’s financial statements are often required to be audited (examined) by an independent

accounting firm in accordance with specified auditing standards. The independent auditor then
provides a written opinion on the financial statements which is known as an audit report. The
purpose of an audit of financial statements is to obtain reasonable assurance about whether the
financial statements as a whole are free from material misstatement, whether due to fraud or
error, thereby enabling the auditor to express an opinion on whether the financial statements are
prepared in accordance with applicable regulations and laws.
The auditor can express one of the three following opinions in the audit report after examination
of all financial statements:
 Unqualified Opinion: Reasonable assurance that financial statements are fairly
presented. This is the one analysts would like to see in a financial report.
 Qualified Opinion: Some misstatement or exception to accounting standards
 Adverse Opinion: Financial statements are materially misstated
In some cases, auditors issue a disclaimer of opinion. This happens when the auditors are unable
to issue an opinion due to some reason, such as scope limitation.
3.2 Other Information Sources
Other information sources that a company can provide include interim reports and proxy
statements. Interim reports are provided by the company either semiannually or quarterly,
depending on applicable regulatory requirements. These include the four financial statements and
condensed notes but are not audited. They are useful for obtaining updates on a company’s
performance and its financial position since the last annual period.
Proxy statements are statements distributed to shareholders about matters that are to be put to a
vote at the company’s annual (or special) meeting of shareholders. They typically contain useful
information regarding:
 Management and director compensation

 Stock performance
 Potential conflicts of interest between management, the board and shareholders
Companies also provide relevant current information on their web sites, in press releases and in
conference calls with analysts and investors.
4. Financial Statement Analysis Framework
The CFA Institute recommends an analysis framework that analysts can use in a variety of
positions within the investment management industry. The framework is summarized in the
figure below. The blue boxes represent the phases of financial analysis while the white boxes
represent the outputs from that phase.
4.1 Articulate the Purpose and Context of Analysis
It is essential to understand the purpose of the analysis, based on the analyst’s role in the
organization. For example, an equity analyst analyzes the financial reports in order to decide
whether to invest in the company or not. On the other hand, a credit analyst looks at the company
in a very different light in order to judge whether it should be given a loan or not. Next, the
analyst defines the context which includes details such as the intended audience, time frame,
budget and so on. Once the purpose and the context are defined, the analyst compiles the specific

questions to be answered by the analysis, decides on the content to be prepared and finalizes the
timeline and the budget.
4.1 Collect Data
Next, the analyst collects data required to answer the questions compiled in the previous step. In
addition to the past and the current financial statements, the analyst should try to obtain industry
and economic data and have discussions with the management regarding the company’s
operations and its future outlook. The analyst can also have discussions with the company’s
suppliers, customers and competitors to further obtain data for his or her analysis.
4.2 Process Data
After obtaining the required data, the analyst processes this data using the appropriate analytical
tools. At this stage, this will involve:
 Reading and evaluating financial statements for each company being analyzed
 Making any adjustments to the financial statements to facilitate comparison. This is
useful when the unadjusted statements of the subject companies reflect differences in
accounting standards, accounting choices or operating decisions.
 Preparing or collecting common-size financial statements (which scale data to directly
reflect percentages or changes) and financial ratios.
4.3 Analyze/Interpret the Processed Data
The next step is to interpret the output. The analyst uses this interpretation to support his
conclusions or recommendations. For example, an equity analyst may require a buy, hold or sell
decision. In support of his decision, he will cite information such as target value, relative
performance, expected future performance and other information used to reach this decision.
4.4 Develop and Communicate Conclusions/Recommendations
Next, the analyst communicates the conclusions or recommendations in the appropriate format.
The format varies by analytical task, by institution and/or by audience. For example, an equity

analyst’s report typically includes summary and investment decision, earnings projections,
valuation, industry & competitive analysis, and other information.
4.5 Follow-up
The financial analysis process does not end with a report. If an equity investment is made or a
credit rating is assigned, period review is necessary to determine if the original conclusions are
still valid. In the case of a rejected investment, follow-up can be useful to determine if the
financial analysis is adequate or should be refined. Follow up can include repeating all the
previous steps on a periodic basis.
Summary
Note: This summary has been adapted from the CFA Program curriculum.
The information presented in financial and other reports, including the financial statements,
notes, and management’s commentary, help the financial analyst to assess a company’s
performance and financial position. An analyst may be called on to perform a financial analysis
for a variety of reasons, including the valuation of equity securities, the assessment of credit risk,
the performance of due diligence in an acquisition, and the evaluation of a subsidiary’s
performance relative to other business units. Major considerations in both equity analysis and
credit analysis are evaluating a company’s financial position, its ability to generate profits and
cash flow, and its ability to generate future growth in profits and cash flow.
This reading has presented an overview of financial statement analysis. Among the major points
covered are the following:
 The primary purpose of financial reports is to provide information and data about a
company’s financial position and performance, including profitability and cash flows. The
information presented in financial reports—including the financial statements and notes—
and other reports—including management’s commentary or management’s discussion and
analysis—allows the financial analyst to assess a company’s financial position and
performance and trends in that performance.

 The basic financial statements are the statement of financial position (i.e., the balance sheet),
the statement of comprehensive income (i.e., a single statement of comprehensive income or
two statements consisting of an income statement and a statement of comprehensive income),
the statement of changes in equity, and the statement of cash flows.
 The balance sheet discloses what resources a company controls (assets) and what it owes
(liabilities) at a specific point in time. Owners’ equity represents the net assets of the
company; it is the owners’ residual interest in or residual claim on the company’s assets after
deducting its liabilities. The relationship among the three parts of the balance sheet (assets,
liabilities, and owners’ equity) may be shown in equation form as follows: Assets =
Liabilities + Owners’ equity.
 The income statement presents information on the financial results of a company’s business
activities over a period of time. The income statement communicates how much revenue and
other income the company generated during a period and what expenses, including losses, it
incurred in connection with generating that revenue and other income. The basic equation
underlying the income statement is Revenue + Other income – Expenses = Net income.
 The statement of comprehensive income includes all items that change owners’ equity except
transactions with owners. Some of these items are included as part of net income, and some
are reported as other comprehensive income (OCI).
 The statement of changes in equity provides information about increases or decreases in the
various components of owners’ equity.
 Although the income statement and balance sheet provide measures of a company’s success,
cash and cash flow are also vital to a company’s long-term success. Disclosing the sources
and uses of cash helps creditors, investors, and other statement users evaluate the company’s
liquidity, solvency, and financial flexibility.
 The notes (also referred to as footnotes) that accompany the financial statements are an
integral part of those statements and provide information that is essential to understanding
the statements. Analysts should evaluate note disclosures regarding the use of alternative
accounting methods, estimates, and assumptions.
 In addition to the financial statements, a company provides other sources of information that
are useful to the financial analyst. As part of his or her analysis, the financial analyst should

read and assess this additional information, particularly that presented in the management
commentary (also called management’s discussion and analysis [MD&A]).
 A publicly traded company must have an independent audit performed on its annual financial
statements. The auditor’s report expresses an opinion on the financial statements and
provides some assurance about whether the financial statements fairly present a company’s
financial position, performance, and cash flows. In addition, for U.S. publicly traded
companies, auditors must also express an opinion on the company’s internal control systems.
 Information on the economy, industry, and peer companies is useful in putting the company’s
financial performance and position in perspective and in assessing the company’s future. In
most cases, information from sources apart from the company are crucial to an analyst’s
effectiveness.
 The financial statement analysis framework provides steps that can be followed in any
financial statement analysis project. These steps are:
a) articulate the purpose and context of the analysis;
b) collect input data;
c) process data;
d) analyze/interpret the processed data;
e) develop and communicate conclusions and recommendations; and follow up.
Next Steps
 Solve the practice problems in the curriculum.

 Solve the IFT Practice Questions associated with this reading.
 Review the learning outcomes presented in the curriculum. Make sure that you can perform
the implied actions.

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Financial Statement

IFT Notes for the CFA® exam

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2. Scope of Financial Statement Analysis

The performance of a company can include an assessment of a company’s profitability, ability to

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3. Major Financial Statements and Other Information Sources

Companies prepare financial reports at regular intervals (annually, semiannually, and/or

3.1 Financial Statements and Supplementary Information

A complete set of financial statements include:

3.1.1 Balance Sheet

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3.1.2 Statement of Comprehensive Income

3.1.2.1 Income Statement

Expenses and Losses

Net Income $114,900

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3.1.2.2 Other Comprehensive Income

3.1.3 Statement of Changes in Equity

3.1.4 Cash Flow Statement

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Cash flows from investing activities:

Cash flows from financing activities:

Net increase in cash $1,550,000

Cash balance at January 1 100,000

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3.1.5 Financial Notes and Supplementary Schedules

3.1.6 Management Commentary or Management Discussion and Analysis

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3.1.7 Auditor’s Report

A company’s financial statements are often required to be audited (examined) by an independent

3.2 Other Information Sources

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4. Financial Statement Analysis Framework

4.1 Articulate the Purpose and Context of Analysis

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4.1 Collect Data

4.2 Process Data

4.3 Analyze/Interpret the Processed Data

4.4 Develop and Communicate Conclusions/Recommendations

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 Solve the practice problems in the curriculum.

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