Study session eight in the CFA Level 1 curriculum includes four readings (25-28) and covers the three main financial statements along with financial analysis techniques.
** If you want a career in finance or investment analysis, if this is really what you want to do, then you absolutely must embrace this reading. The four readings present the underlying concepts of how the financial statements represent a firm’s performance. Not only will this material be the core of your study for the CFA exams, your professional career will most likely revolve around it.
The reading is so important and so testable that we will be spending two weeks here for our 21-week study plan. You may want to keep on the one-study session per week schedule if you already have a good grasp of the statements and basic analysis.
So spend a little extra time on this study session if you have not already mastered it from previous courses. The time spent here will pay off this June and in the other exams as well.
Understanding Income Statements
The income statement measures the company’s performance over a period of time. The main point is that revenues and related expenses are matched during the period in which they occur. This is supposed to give a better measure of performance than a cash accounting. The problem is that management often has a strong incentive to manipulate the revenues, expenses and other items to show earnings in a different light.
It’s important to understand the basic structure of the statement and what each line item represents:
- Net Sales is gross revenue minus any allowances for returns
- Cost of goods sold is really what it sounds like and is the inventory cost, here it is important to understand inventory accounting procedures like LIFO, FIFO, or average cost to understand how management is expensing it
- Gross Profit is the difference between net revenue and COGS (also used to find Gross Margin) and is your first measure of profitability
- Selling, General & Administrative is all direct and indirect expenses that can be linked to operations (salaries, rent, utilities, marketing, pretty much everything that is not associated with the cost of inventory itself)
- Operating income (profit) is the result of operations and your second measure of profitability (profit margin = operating income/ net revenue)
- Interest expense is just the interest on debt for the period
- Nonrecurring items- discussed below
- Provision for income taxes represents the estimated tax liability and gives an indication of the effective tax rate
- Net income is your final measure of profitability (net margin = net income/net revenue)
A theme throughout the curriculum is the preference for conservative accounting principles, as opposed to aggressive practices. Conservative principles are those that take the ‘safe’ bet when recognizing revenues or expenses (and usually less favorable to short-term reporting).
Understand how to calculate the two methods for revenue recognition of long-term projects and the SEC’s four criteria for revenue recognition:
- Legitimate arrangement between buyer and seller
- Delivered or rendered the product or service
- Price is or can be determined
- The seller can be reasonably assured of collection
Nonrecurring items that are unusual or infrequent (but not both) are reported as part of earnings from continuing operations and are often a way for management to take large expenses up front instead of in the future. Examples are: restructuring costs, asset impairment charges, gains or losses on sale of long-lived assets.
Those nonrecurring items that are unusual and infrequent (extraordinary) or discontinued operations are reported net of taxes below income from continued operations. Because these are so out of the ordinary, analysts do not normally consider them against performance. As with those nonrecurring items included in continuing operations, analysts must decide whether they are appropriately reported.
Remember that some items are not reported on the income statement but go “direct to equity” as other comprehensive income. The easiest way to remember these is by the PUFE acronym for:
- Pensions or additional minimum pension liability
- Unrealized gains or losses on available for sale securities
- Foreign currency exchange translations on hedging
- Effective portion of cash flow hedges
You are not asked to do much with the Statement of Comprehensive Income at level I but just understand the basic relationship and what each of the four items represents.
Understand which changes to accounting standards must be reported retrospectively (changes to accounting principles) and which must be treated prospectively with no adjustments to prior periods (changes to estimates) and that corrections of prior period errors require a restatement of financial statements.
Be able to calculate earnings per share for both a simple (just NI minus preferred dividends over weighted average common shares) and complex capital structure (basic EPS adjusted for After-tax interest on convertible and common share adjustments for assumed conversions).
Understanding Balance Sheets
Unlike the other two statements, the balance sheet is a ‘snapshot’ in time. The figures reflect the state of accounts at that moment, the last day of the quarter or year. The other two statements represent activity over the period. For this reason, and this is very important, when you perform ratio analysis comparing numbers across the statements you will take an average of the beginning and ending figures for balance sheet accounts. For example, the cash debt coverage is cash-flow from operations divided by average total debt from beginning and ending balance sheet date.
You’re going to get tired of people saying, “Assets = Liabilities + Equities.” This is the basic balance sheet equation and around which much of the material will revolve around. Understand what it shows when you change around the equation (i.e. A-L = E) and you’ll get the importance of the concept.
One of the most important topics on the statement is valuation. Some accounts are shown at historical or amortized price, while others are shown at fair (market) value. Obviously this makes a big difference in overall valuation and when comparing numbers. Further, analysts often will adjust the numbers to arrive at a number they feel is more realistic or comparable. You aren’t asked to do this but just to understand where it might be needed and why. The definitions below will each describe the method of valuation for the account.
Assets represent a future probable economic benefit and could be accumulated items, amounts spent but not yet expensed (matched with revenues) or amounts earned but not yet received (accounts receivable).
Current assets are the most liquid and are accumulated or planned to be used in the ‘current’ operating period. Normally recorded at fair market value.
Cash or cash equivalents- is usually short-term money market, CDs, commercial paper or treasuries that can be converted to cash quickly. This is used in all your liquidity ratios and is (duh) valued at market.
Accounts receivable– Sales made on credit but not collected, usually offset by an allowance for uncollectable (estimated) but shown net realizable (fair) value. Trends in AR are an important indication of performance and estimates.
Inventories- A key item and one you’ll spend a lot of time on through the curriculum. Reported at lower of cost or market on the balance sheet but estimated through different practices (LIFO, FIFO, or average). Could be broken down into three sub-accounts: raw materials, work-in-process, and finished goods.
Prepaid expenses– Where the company has paid in advance for a service or product, i.e. insurance and rent. Valued at market with an adjustment when they are expensed through the income statement.
Long-term assets have a useful life of more than a year (or operating cycle) and are usually not going to be sold to customers. These accounts are usually recorded at cost and then depreciated or amortized over the estimated life.
Property, Plant, & Equipment – valued at cost and depreciated over its estimated useful life, shown as net. These are also referred to as ‘tangible’ assets because they generally have physical substance and are easily counted.
Goodwill & other intangibles– Goodwill is the amount paid for acquisitions above their market value. It is basically a premium paid for things like brand and proprietary technology. It is recorded at cost and tested annually for impairment, which is an estimation of the value that no longer exists.
Liabilities are future probable sacrifices from obligations or transactions and could be: amounts received but not earned yet as revenue, amounts received that must be repaid or amounts expensed on the income statement but not yet paid (accounts payable, accruals, etc).
Current liabilities are those that will be paid or settled in the ‘current’ operating cycle.
Accounts Payable– suppliers have sold something to the company on credit that must be repaid. As with AR, you’ll look for trends in this to see that the company is not taking longer to pay. Valued at market.
Accrued liabilities– Those items expensed in the current period but that will not be paid until the next period, kind of a carry-over effect of timing, i.e. wages and interest owed but not paid yet. Valued at market.
Short-term debt- includes lines of credit and notes with an original maturity of less than a year (negotiated debt).
Current portion of long-term debt – principal portion of long-term notes including any capital lease obligations.
Unearned revenue- sales collected in advance but not yet earned so they sit here until delivered or performed. Settled as revenue on the income statement instead of through a cash adjustment.
Long-term liabilities is often a single line item for debt but can also be broken out into items like: bonds and notes payable, long-term lease obligations, deferred taxes and pension liabilities.
Equity is the residual after assets and liabilities and that which is due the owners of the company. It includes: capital contributed by owners through stock, recognized on the income statement but not yet paid out to owners (retained earnings) and adjustments to assets or liabilities that did not go through the income statement (see other comprehensive income in prior post).
Contributed capital– is supplied by stockholders and broken into common, preferred and additional paid-in-capital.
Minority interest – This is the cumulative, noncontrolling ownership held in other companies.
Retained earnings– accumulated net income due to owners but not yet paid out.
Treasury stock – amount paid to repurchase company stock usually shown as a negative number because it decreases equity.
We will conclude the study session next week with the Statement of Cash Flows and some notes on financial analysis.
‘til next time, happy studyin’
Jospeh Hogue, CFA