The material on financial statements is extremely important on the CFA exams and used on a daily basis by professionals in the industry. The section is just as important for the Claritas Investment Certificate and is one of the five chapters in Module 3 that account for 20% of your exam score.
The intro material is fairly general. It looks like a lot of Claritas revolves around understanding the various participants in the capital markets and their roles. Remember this as you read through the curriculum. You are not expected to know the details of what every participant does but just understand their general role and reasons.
Participants and uses of financial statements include: management, employees, investors, tax authorities and investment analysts.
- Besides a summary of past performance, financial statements also provide information that can be used to forecast performance
Statements follow one of two accounting standards:
- International Financial Reporting Standards (IFRS)
- Established by the International Accounting Standards Board (IASB)
- Generally Accepted Accounting Principles
- Used by most U.S. based publicly-traded companies
Though there are standards and rules that must be followed, management still has flexibility in how they report many items on the statements. It is for this reason that so much time is spent analyzing the statements to develop a clear picture of the company’s future.
The statements must be audited by an independent firm, which provides one of three opinions on the fairness of reporting **not a judgment on the company’s performance or stability
This section gets fairly deep into some accounting concepts. As with the other technical portions of the curriculum, I would recommend that you get the bigger picture first. Understand the three basic financial statements, what each shows and their interrelationship first. Only after you’ve got this then start worrying about smaller details like the accounting treatment for individual line items. You won’t get every point on the exam, but you will get the big ideas to get you a passing score.
The Balance Sheet shows all the resources (assets) owned by the company and the sources of financing (liabilities and equity). One of the biggest differences with the other statements is that the balance sheet shows everything as of a specific point in time, the last day of the fiscal year or quarter.
Assets are either current (short-term, less than a year) or long-term (things like property, plant and equipment used for many years)
Liabilities are also either current (must be paid within the year) or long-term (usually loans with many years left to pay)
Shareholder equity is the portion of profits that have not been paid out and still remain to the owners of the company
The Income Statement shows the company’s sales and profits that occurred over the entire period. For starters, understand the following keywords and their place in the statement: Revenue (sales) minus operating expenses equals EBIT minus interest and taxes equals net income. Net income from the statement is used as the first line item to construct the statement of cash flows.
The Statement of Cash Flows shows the cash receipts and uses of cash that occurred over the entire period. The statement is extremely useful because it shows actual cash movements rather than following the accrual method of accounting used in other statements.
The statement is broken into three segments: cash flows from operating activities (cash generated from daily business), cash flows from investing (cash from buying or selling long-term assets) and cash flows from financing activities (cash from borrowing or repaying money). The change in cash from these three segments ends up on the Cash balance at the top of the Balance Sheet.
Although not really another statement, the Notes to the Financial Statements are also very important and provide some key assumptions and details used in the other three statements.
Financial Statement Analysis
Ratios play a big part of analysis because they are fairly simple to understand and can help to compare companies.
Liquidity ratios measure the company’s ability to pay their short-term liabilities (loans)
- Current ratio (current assets/current liabilities)
- Quick ratio [(current assets – inventories)/current liabilities]
Profitability ratios measure the overall performance and efficiency of the company
- Net profit margin (net income/revenue)
- Operating margin ( operating income/revenue)
- Return on assets (net income/ total assets)
Financing ratios measure the amount of debt and the ability to meet loan obligations
- Debt-to-equity (debt/equity)
Return measures measure the amount earned for owners
- Return on Equity (net income/equity) also (net profit margin*asset turnover*financial leverage)
Market value ratios measure the price of the stock against another metric
- Price-to-earnings (price/earnings per share)
- Price-to-book (price/ company book value)
If the math scares you a little (x/y), just try thinking in terms of how much of x does the company have to cover y or how much of x have they been able to earn for their amount of y.
It’s a detailed chapter and probably more than many were expecting. Keep at it and do your best. Certificate or no, this information is extremely valuable and used every day in your industry. Knowing it will only make you better at your career and an asset to your employer.
‘til next time, happy studyin’
Joseph Hogue, CFA