Don’t neglect this basic information on financial statements in the CFA curriculum
One of the most important topic areas in the CFA curriculum is Financial Statement Analysis, which accounts for upwards of 20% of each exam’s points. Reading 22 of the Level I CFA Program curriculum is your first step into the world of financial statement analysis and a critical skill you’ll need during your career.
I thought it would be helpful to point out some of the highlights of the Finquiz Study Notes on the reading and some other tips to the Level 1 CFA material within financial statement analysis. Over the next few weeks, we’ll cover the other key topic areas and readings in the CFA level 1 exam to help you get the most points possible.
An Introduction to Financial Statement Analysis
The Finquiz study notes for Reading 22 is eight pages long and covers all the learning outcome statements for the material. Rather than a substitute for the curriculum, Finquiz notes are meant to complement your reading of the CFA curriculum to make sure you cover all the material and reinforce the most important points.
The overview section on financial statements and supplementary information is a brief outline of purpose for the financial statements and other information you’ll need to research as an analyst.
Balance Sheet – a snapshot of the company’s financial position at one moment in time. The ‘snapshot’ idea is important because the other financial statements show activity over the entire period. Since the balance sheet differs in presentation, you’ll need to adjust the numbers when comparing against the other statements, i.e. taking an average of the beginning and ending balance sheet amounts.
The balance sheet categorizes everything broadly into assets, liabilities and owners’ equity. Within assets and liabilities, the items are also categorized by short-term and long-term in terms of liquidity.
The Income Statement is the financial results of a company over the quarterly or annual period. Revenues and expenses are recorded according to accrual accounting principles meaning they are matched appropriately though may not reflect actual cash activity.
Your first task will be to understand the difference between items that go in normal operating expenses and those that appear below because they are unusual or infrequent. You’ll also need to understand the general layout of the income statement and ratios like gross margin, operating margin and net margin.
While the income statement is popular with investors, you’ll spend much of your time on the Statement of Cash Flows as an analyst. The statement is an accounting of the actual cash flows of the business over the period. Since it represents actual cash flows, it is less easily manipulated by management compared to the income statement so a very valuable tool for analysis.
Cash flows are separated into three categories:
- Operating cash flows are generated from normal day-to-day business operations
- Cash flows from investing are attributed to the company’s long-term investing and disposal of assets
- Cash flows from financing are attributed to the company’s use and sources of capital like debt and returning cash to shareholders
The Statement of Changes in Owners’ Equity is not quite as important as the other financial statements but you will still need a basic understanding of the components and how it relates to the other statements. Components of the statement include: paid-in capital, retained earnings, minority interests and other comprehensive income.
Beyond these four statements, you will also need to remember what supplementary information can be found in the financial statement footnotes and the Management Discussion & Analysis. These supplementary schedules and items are not as important as the financial statements but you’ll need to know what they include.
You won’t use the Auditor’s Report for much of anything but need to know the layout of the report as well as the difference between the four types of opinion.
- Unqualified opinion – indicates that the financial statements appear to be free of material misstatements and are prepared in accordance with accounting principles
- Qualified opinion – indicates some exceptions to accounting standards and perhaps some concerns about the company
- Adverse opinion – indicates material misstatements and problems in the presentation according to accounting principles
- Disclaimer of opinion – is given when an auditor is unable to issue an opinion
Level I CFA Program Review: Financial Statement Analysis Framework
The steps in the analysis framework are not as important as the process itself. Working through the readings on each financial statement will give you a good idea of the process. You might want to briefly look over each of the six steps in the process but it is unlikely that you’ll be tested on knowing the name of a specific step.
- Articulate purpose and context of the analysis – why are you performing the analysis?
- Collect input data – from financial statements and other sources
- Process data – adjusting financial statements, ratios and comparing data on common-size
- Analyze and interpret – produce analytical results
- Develop and communicate conclusions
You’ll go into much more detail on the financial statements and FSA further into the curriculum. Some of this introductory material may seem overly simplified and unnecessary. If you have significant accounting or analysis experience, you can probably skim through it quickly but I would warn against skipping it entirely. The CFA curriculum is very well constructed to be a progressive learning process. Learning the basics in these introductory chapters will make subsequent chapters easier to understand. Skipping the seemingly easy stuff risks missing out on something you will need to know later in the curriculum.
‘til next time, happy studyin’
Joseph Hogue, CFA