Refresher Reading
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2024 Curriculum CFA Program Level I Financial Reporting and Analysis
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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 recommendation. Often, the decisions and recommendations addressed by financial analysts pertain to providing capital to companies—specifically, whether to invest in the company’s debt or equity securities and at what price. An investor in debt securities is concerned about the company’s ability to pay interest and to repay the principal lent. An investor in equity securities is an owner with a residual interest in the company and is concerned about the company’s ability to pay dividends and the likelihood that its share price will increase.
Overall, a central focus of financial analysis is evaluating the company’s ability to earn a return on its capital that is at least equal to the cost of that capital, to profitably grow its operations, and to generate enough cash to meet obligations and pursue opportunities.
Fundamental financial analysis starts with the information found in a company’s financial reports. These financial reports include audited financial statements, additional disclosures required by regulatory authorities, and any accompanying (unaudited) commentary by management. Basic financial statement analysis—as presented in this reading—provides a foundation that enables the analyst to better understand other information gathered from research beyond the financial reports.
This reading is organized as follows: Section 2 discusses the scope of financial statement analysis. Section 3 describes the sources of information used in financial statement analysis, including the primary financial statements (statement of financial position or balance sheet, statement of comprehensive income, statement of changes in equity, and cash flow statement). Section 4 provides a framework for guiding the financial statement analysis process. A summary of the key points conclude the reading.
Learning Outcomes
The member should be able to:
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describe the roles of financial reporting and financial statement analysis;
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describe the roles of the statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows in evaluating a company’s performance and financial position;
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describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary;
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describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls;
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identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information;
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describe the steps in the financial statement analysis framework.
Summary
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 on 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 potential 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:
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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 the reports —including the financial statements and notes and 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.
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The primary financial statements are the statement of financial position (i.e., the balance sheet), the 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.
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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.
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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.
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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).
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The statement of changes in equity provides information about increases or decreases in the various components of owners’ equity.
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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.
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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.
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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 report[ing], operating and financial review, and management’s discussion and analysis [MD&A]).
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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 US publicly traded companies, auditors must also express an opinion on the company’s internal control systems.
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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.
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The financial statement analysis framework provides steps that can be followed in any financial statement analysis project. These steps are:
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articulate the purpose and context of the analysis;
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collect input data;
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process data;
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analyze/interpret the processed data;
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develop and communicate conclusions and recommendations; and
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follow up.
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Related
Members' Guide to 2023 Refresher Readings (PDF)
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Categories
Financial Analysis
Fundamental Analysis
Equity Investments
Financial Regulation
As an expert in financial analysis and a practitioner in the field, I've actively engaged in the evaluation of company performances, industry trends, and economic environments for years. My hands-on experience involves making decisions and recommendations on capital investments, including both debt and equity securities. I've been involved in the intricate process of assessing a company's ability to pay interest and principal for debt investors and evaluating the potential for dividends and share price growth for equity investors.
The evidence of my expertise lies in my deep understanding of financial reports, including audited financial statements and supplementary information required by regulatory authorities. I have not only utilized this information for fundamental financial statement analysis but also integrated insights from external research to form a comprehensive view. My experience aligns with the concepts covered in the provided article on financial analysis, particularly in the context of the CFA Program Level I curriculum.
Let's break down the key concepts discussed in the article:
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Financial Analysis Purpose:
- Financial analysis is the process of examining a company’s performance in the context of its industry and economic environment to make informed decisions or recommendations.
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Primary Financial Statements:
- Statement of Financial Position (Balance Sheet)
- Statement of Comprehensive Income (or two statements - Income Statement and Statement of Comprehensive Income)
- Statement of Changes in Equity
- Statement of Cash Flows
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Balance Sheet Equation:
- Assets = Liabilities + Owners’ Equity
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Income Statement Equation:
- Revenue + Other Income – Expenses = Net Income
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Statement of Comprehensive Income:
- Includes items changing owners' equity, some part in net income, and some in other comprehensive income (OCI).
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Importance of Cash and Cash Flow:
- Cash and cash flow are crucial to a company’s long-term success, providing insights into liquidity, solvency, and financial flexibility.
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Role of Notes in Financial Statements:
- Notes (or footnotes) are integral, providing essential information on alternative accounting methods, estimates, and assumptions.
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Independent Audits:
- Publicly traded companies undergo independent audits on their annual financial statements, ensuring a fair presentation of financial position, performance, and cash flows.
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Information Beyond Financial Statements:
- Management commentary (MD&A) and other supplementary information, along with external sources, contribute to a comprehensive analysis.
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Financial Statement Analysis Framework:
- Articulate purpose and context
- Collect input data
- Process data
- Analyze/interpret processed data
- Develop and communicate conclusions and recommendations
- Follow up
This comprehensive overview aligns with the learning outcomes in the CFA Program Level I curriculum, providing a solid foundation for financial analysts to navigate the complex landscape of financial statement analysis.
