We started our review of the CFA level 1 financial statement material last week with a basic understanding of the financial statements and the framework in analysis. A lot of this introductory material is extremely basic but you should resist the urge to speed through it. Financial Statement Analysis accounts for up to 20% of the points on all three CFA exams and you will need to use it every day during your career as an equity analyst. Most importantly, you’ll need most of this introductory material to understand more detailed concepts and formulas on the CFA Level 2 and Level 3 exams.
We jump right into it this week with a look at the income statement, the major accounting concepts and statement analysis. The income statement is likely the most talked about in the financial press of the three principal financial statements though you’ll spend just as much time as an analyst on the other two statements. We’ll be using the Finquiz notes to the CFA curriculum.
Understanding the Income Statement on CFA Level 1
The income statement represents the company’s profitability over a period of time, either a quarter or through the year. Analysts use the income statement to evaluate the quality of a company’s earnings and earnings growth rate.
You should remember the requirements for revenue recognition under IFRS and U.S. GAAP. The general rules plus recognition of special cases like long-term contracts is highly testable material, especially quick calculations like the percentage-of-sales methodology.
Income from operations is an important number because it shows the operational earnings power of the firm. The operating margin, operating profits divided by sales, can be used to judge the operational efficiency of the company compared to competitors. Operating earnings are sometimes referred to as Earnings Before Interest and Taxes (EBIT) and an important valuation multiple will be on EBITDA, which adds back depreciation and amortization.
Everything below net income from operations is referred to as “below the line” and includes many items that are not part of normal operational activities. The definition and reasons why an activity is reported below the line as non-operating items is very important. Understand the difference between Extraordinary Items (not allowed under IFRS) and Unusual or Infrequent Items.
- Extraordinary Items are both infrequent and unusual, such as losses on natural disasters and expropriations.
- Unusual or Infrequent Items are either/or and are generally reported as part of continuing operations of a company. Common items are restructuring charges or gains/losses on sales of an asset.
Expense recognition around inventory will be very important material so master the LIFO, FIFO and weighted-average costing methods. You’ll see whole readings on this later so getting the basics here will make the more detailed readings easier to grasp. An important point is the effect of different costing methodology on Cost of Goods Sold.
Understand how to calculate Weighted Average Number of Shares Outstanding over a period as well as the difference between a simple and complex capital structure. Understand the difference between basic EPS and diluted EPS along with which securities are used in the calculation of dilution (i.e. options, warrants, convertible debt, convertible preferreds).
CFA Level 1 Income Statement Analysis
The focus on the CFA level 1 exam is placed on understanding the layout and accounting of the income statement rather than detailed analysis. The analysis in Reading 25 is fairly basic and just covers common-size statements and margins.
Common-size financial statements are a way of comparing statement items against a major line item like sales or assets. In vertical common-size analysis, you find the percentage of each line item relative to sales for each year. This is helpful in seeing if particular expenses have become larger or smaller in significance. In horizontal common-size analysis, you base each line item off of itself in a common year. It helps to see changes in expenses over the years.
Three margin ratios are common in income statement analysis,
- Gross margin is the percentage of revenue after cost of sales and may help show different competitive strategies across companies
- Operating margin is the percentage of revenue after operating expenses and is valuable in showing how well management controls costs
- Net margin is income divided by sales and shows the overall income statement profitability
This basic statement analysis is detailed further in Reading 28 of the CFA level 1 curriculum which brings the financial statements together for a closer look at analysis and ratios. These are some of the most important readings you’ll cover within the curriculum and for your job as an analyst so make sure you spend as much time as it takes to master the material.
‘til next time, happy studyin’
Joseph Hogue, CFA