Financial Statement Analysis for CFA Level 1: Unlock the Secrets of Financial Reports

In this section, we’ll dive into the Financial Statement Analysis topic of the CFA Level 1 exam, guiding you through each reading to help you unlock the secrets of financial reports. So, let’s roll up our sleeves and start dissecting those financial statements!

1. Introduction to Financial Statement Analysis

Venture into the world of financial statement analysis, taking a deep dive into balance sheets, income statements, and beyond. This journey will help you decipher the concealed messages in footnotes and management’s discussion and analysis, morphing you into a financial detective.

• Major Financial Statements: Discover the finesse of financial statement analysis and delve into the complexities of balance sheets and income statements.
• Financial Statement Analysis Framework: Immerse yourself in the financial statement analysis framework, transforming into a financial maestro who can generate impactful insights.
• Standard Setting Bodies: Discover the pivotal roles of standard-setting bodies like the IASB and FASB, and how they, alongside regulatory authorities, ensure consistency in the world of financial reporting.
• Auditor’s Report and Other Sources of Information: Learn to traverse through auditor’s reports and other treasure troves of information, evolving into a proficient financial investigator.
• Comparison of IFRS with Alternative Financial Reporting Systems: Leap into the convergence of financial reporting standards, appreciate the collaborative efforts of IASB and FASB, and develop the art of interpreting financial statements as an analyst, focusing on the significance
• The IFRS Framework: Venture into the IFRS framework, grasp the essential elements of reporting, understand the underlying assumptions, and get acquainted with the constraints and trade-offs of financial statements, all while meeting IAS 1, the sentinel of financial statement structure.

2. Analysing Income Statements

Income statements provide a comprehensive overview of a company’s financial health, breaking down revenues, expenses, and other critical financial elements. The knowledge of various components and their recognition methods such as revenue, inventory expenses, depreciation, and amortization allows for more detailed analysis. Mastery of earnings per share (EPS), both basic and diluted, along with the understanding of non-recurring and non-operating items, common-size and ratio analysis, and comprehensive income are key to accurate financial statement analysis.

• Components and Format of an Income Statement: Get a thorough understanding of the components like revenues, expenses, gains, losses, and formats like single-step and multi-step of an income statement.
• Revenue Recognition: Uncover the five-step process of revenue recognition and the intricacies of long-term contracts, variable consideration, and contract modifications.
• Inventory Expense Recognition: Discover various inventory expense recognition methods such as FIFO, LIFO, and weighted average cost, and the potential pitfalls of expense recognition manipulation.
• Depreciation and Amortisation Expense Recognition: Grasp the essentials of expense calculations using the straight-line method and accelerated methods, and learn about the potential risks like impairment and subjectivity.
• Non-Recurring Items and Non-Operating Items: Identify and analyze the impact of non-recurring and non-operating items like discontinued operations, extraordinary items, unusual or infrequent items, and accounting changes.
• Basic Earnings Per Share: Understand the calculation and significance of basic EPS and the impact of stock splits and stock dividends on this metric.
• Diluted Earnings Per Share: Learn the impact of convertible preferred stock, convertible bonds, and stock options on diluted EPS calculations.
• Common-Size and Ratio Analysis: Master the techniques of common-size analysis and income statement ratios to effectively compare companies of different sizes and decipher their strategies.
• Comprehensive Income: Navigate the complex landscape of comprehensive income, including its connection to retained earnings and the dynamics of foreign currency translations, pension liabilities, and unrealized gains or losses.

3. Analysing Balance Sheets

A balance sheet is a snapshot of a company’s financial status, detailing its assets, liabilities, and owner’s equity. The ability to dissect and understand the various components, including current and non-current assets and liabilities, as well as comprehend the concept of owner’s equity, is crucial. Furthermore, the ability to analyze balance sheets, particularly through liquidity and solvency ratios and common-size analysis, provides valuable insights into an entity’s financial stability.

• Components and Format of the Balance Sheet: Discover the essential elements of a balance sheet – assets, liabilities, and owner’s equity – and learn about their classifications and analysis.
• Current Assets: Learn about different types of current assets, such as cash and cash equivalents, marketable securities, accounts receivable, inventories, and prepaid expenses.
• Current Liabilities: Get acquainted with various types of current liabilities including accounts payable, notes payable, accrued liabilities, and unearned revenue and their impact on a firm’s financial health.
• Non-current Assets: Traverse the world of non-current assets, learning about tangible and intangible assets, financial assets, and their effects on balance sheets.
• Non-Current Liabilities: Understand the role of long-term financial liabilities and deferred tax liabilities, and their representation on balance sheets.
• Owners’ Equity: Uncover the complexities of owners’ equity, including its various components and their role in the statement of changes in stockholders’ equity.
• Analysis of Balance Sheets: Acquire the skills to analyze balance sheets, focusing on liquidity and solvency ratios, and trend identification and comparison through common-size analysis.

4. Analysing Cash Flow Statements

Cash flow statements, with their unique capacity to capture the movement of money through a business, serve as critical financial tools. A thorough understanding of the principles and classifications of cash flows, as well as the methods of presenting these cash flows, is key to navigating these statements. Developing the ability to analyze cash flow statements, understanding sources and uses of cash, free cash flow, and cash flow ratios, can reveal important insights about a company’s financial health and performance.

• Principles and Classification of Cash Flows: Grasp the categories of cash flows – operating, investing, and financing – and the distinct role of non-cash transactions.
• Methods of Presentation: Learn the direct and indirect methods for presenting cash flows and their implications for CFO calculations.
• Analysis of Cash Flow Statements: Develop skills to analyze cash flow statements, focusing on sources and uses of cash, free cash flow, cash flow ratios, and common-size analysis.

5. Analysis of Inventories

Inventory topics are an essential aspect of financial accounting, and a solid understanding of them is vital for your success. Through this journey, you’ll master inventory accounting, explore various inventory valuation methods, and delve into the specifics of the LIFO method. By the end of it, you’ll be well equipped to tackle any inventory-related question or task that comes your way.

• Inventory Accounting: Learn to master the inventory equation, understand cost capitalization and expensing, and handle inventory adjustments when valuation falls below cost.
• Inventory Valuation Methods: Unlock the secrets of the four main inventory valuation methods and grasp the differences between periodic and perpetual inventory systems.
• The LIFO Method: Familiarize yourself with the ins and outs of the LIFO method, including LIFO reserve, LIFO liquidation, and the required presentation and disclosures for inventories.
• Presentation and Disclosures of Inventories: Unpack the essentials of inventory presentation and the significance of disclosures under IFRS and US GAAP, alongside analytical tools like inventory turnover and gross profit margin.

6. Analysis of Long-Term Assets

Welcome aboard the long-lived assets express, where you’ll explore the fundamentals of capitalisation, depreciation, amortisation, and the methods of dealing with impairments, revaluation, and derecognition. With these tools in your arsenal, you’ll have a firm grip on this crucial aspect of financial accounting and analysis.

• Capitalisation of Long-Lived Assets: Discover the world of capitalisation and expensing, and their respective impacts on financial statements and ratios.
• Depreciation of PP&E: Understand the ins and outs of various depreciation methods and how they affect financial statements.
• Amortisation of Intangibles: Master the classification and cost allocation of intangible assets over their useful lives.
• Impairments, Revaluation and Derecognition: Get to grips with the IFRS and US GAAP treatments of impairments, revaluation, and derecognition, and their effects on financial statements and ratios.
• Using Long-Term Asset Disclosures in Analysis: Get equipped to analyze long-lived assets with precision, using disclosures on PP&E and intangible assets under IFRS and US GAAP.

7. Topics in Long-Term Liabilities and Equity

Embark on a captivating journey through the world of non-current liabilities, a critical component in understanding a company’s long-term financial health. You’ll start with an in-depth exploration of bonds, then navigate the complexity of leases, followed by the intricacies of pension plans. Finally, you’ll climb the heights of solvency ratios, decoding the company’s ability to meet long-term obligations.

• PRE: Bonds I: Get a firm grasp of bond issuance, covering key components, financial statement effects, and bond amortization methods.
• PRE: Bonds II: Delve deeper into the world of bonds, learning about issuance costs, debt covenants, and the necessary financial statement presentations and disclosures.
• Leases: Unravel the complexities of lease accounting, from finance to operating leases, their presence on balance sheets, and the differences under IFRS and US GAAP.
• Pension Plans: Understand the workings of defined contribution and benefit plans, along with their respective financial reporting requirements.
• Share-based Compensation: Get to grips with the essentials of share-based compensation, from stock options to performance shares, and their role in financial analysis.

8. Analysis of Income Taxes

Dive into the captivating universe of deferred taxes, an essential element of financial accounting that can significantly influence a company’s financial health. In this journey, you’ll first understand the disparities between financial accounting and tax reporting, and later, you’ll uncover the effects of tax rate changes on financial statements. By the end of this exploration, you’ll have a comprehensive understanding of deferred taxes.

• Deferred Taxes I: Understand the differences between financial accounting and tax reporting, along with the intricacies of deferred tax assets and liabilities.
• Deferred Taxes II: Explore the impact of tax rate changes on financial statements and the dissimilarities in accounting practices between IFRS and US GAAP.

9. Financial Reporting Quality

Immerse yourself in the critical domain of financial reporting quality, where understanding the intricacies can significantly influence financial decision-making. Get to grips with the pivotal concepts of financial reporting quality and the factors that may prompt management to opt for low-quality reporting. Next, put on your detective hat and delve into the intrigue of accounting bias and earnings manipulation, learning to spot the signs.

• Financial Reporting Quality Concepts: Gain insights into distinguishing high-quality earnings from temporary ones, comprehend the varied motivations for low-quality financial reporting, and get acquainted with disciplinary actions.
• Accounting Bias and Earnings Manipulation: Explore the maze of biased reporting, get versed in various earnings manipulation techniques, and learn to identify the warning signs of potential manipulation.

10. Financial Analysis Techniques

Financial analysis techniques are key to understanding a company’s performance and guiding decision-making. These techniques encompass everything from the financial statement analysis framework to ratio analysis, common-size analysis, and more. Additionally, understanding and interpreting various financial ratios, including activity, liquidity, solvency, and profitability ratios, as well as gaining proficiency in equity and credit analysis, will provide a comprehensive perspective of a company’s financial standing.

• Analytical Process, Tools and Techniques: Discover the tools and techniques needed to transform financial data into valuable insights.
• Activity, Liquidity, and Solvency Ratios: Master the calculation and interpretation of key financial ratios to gauge a company’s efficiency, liquidity, and long-term solvency.
• Profitability Ratios and DuPont Analysis: Unlock the power of profitability ratios and DuPont analysis in evaluating a firm’s financial health.
• Equity and Credit Analysis: Learn the ropes of equity valuation and credit analysis using valuation ratios, segment reporting, and forecasting models.

11. Introduction to Financial Statement Modeling

Get ready to explore the essentials of financial statement modeling, where you’ll grasp the impact of inflation and deflation on business operations and dive into the nitty-gritty of long-term forecasting. This is your ticket to understanding the dynamics of financial predictions and strategic planning in finance.

• Modelling Inflation and Deflation: Unpack how inflation and deflation affect business strategies and pricing.
• Long-Term Forecasting: Learn the ropes of crafting financial forecasts that stand the test of time.

12. [Prerequisite] Financial Statement Analysis – Applications

Venture into the captivating sphere of financial statement analysis applications. Kickstart your journey with the analysis of past performance and the forecasting of future outcomes using essential financial tools. Then, polish your detective skills with credit quality assessment and equity screening, and finally, master the art of adjusting financial statements for comparability.

• Analyzing Past and Forecasting Future Performance: Acquire skills to scrutinize a company’s financial history and make future predictions using ratio and common-size analysis.
• Credit Quality Assessment and Equity Screening: Get well-versed in analyzing a company’s creditworthiness and the role of credit rating agencies, plus understand the intricacies of equity screening strategies.
• Adjusting Financial Statements for Comparability: Learn how to adjust financial statements for various investment securities classifications, unravel the differences between IFRS and US GAAP, and handle LIFO/FIFO debates.

Wrapping Up: Mastering Financial Statement Analysis for CFA Level 1

And there you have it – a comprehensive breakdown of the Financial Statement Analysis topic in the CFA Level 1 exam! Remember to stay focused, practice plenty of questions, and enjoy the process of uncovering the stories hidden within financial statements. After all, who said finance couldn’t be a thrilling adventure? Good luck, and may your financial analysis skills guide you to CFA success!