Introduction to Major Financial Statements | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Welcome to the world of financial statement analysis! In this lesson, we will cover the basics of financial statements, footnotes, and management’s discussion and analysis (MD&A). Let’s dive in!

Why Financial Statement Analysis?

Companies are required to publish regular financial reports, providing information on their performance, financial position, and changes in financial position. Analysts use these reports, along with other information, to form expectations about a company’s future profitability and cash flow. This process, known as financial statement analysis, helps in making investment, credit, and other economic decisions.

Key Financial Statements

There are five major financial statements:

• Balance Sheet
• Income Statement
• Other Comprehensive Income Statement
• Statement of Changes in Equity
• Statement of Cash Flows

Balance Sheet

The balance sheet is a snapshot of a firm’s financial position, consisting of three elements:

• Assets: Resources controlled by the firm, including cash.
• Liabilities: Amounts owed to creditors and lenders.
• Owner’s Equity: The owners’ residual claim on the company’s assets after deducting its liabilities.

The balance sheet must always be balanced, meaning assets equal the sum of liabilities and owner’s equity.

Income Statement

The income statement, sometimes known as the profit and loss statement, accounts for the net income of the firm for a given period. Net income is calculated as revenues minus expenses plus other income:

• Revenues: Inflows from delivering or producing goods, rendering services, or other activities that constitute the firm’s central operations.
• Expenses: Outflows in the process of running operations, depreciation of assets, and incurrence of liabilities that decrease equity.
• Other Income: Gains that may or may not arise in the ordinary course of business.

Other Comprehensive Income Statement

Other comprehensive income includes gains and losses that are excluded from the income statement. Examples of such items are unrealized gains or losses on investments classified as available for sale, foreign currency translation gains or losses, and pension plan gains or losses.

Total comprehensive income is the sum of net income and other comprehensive income. Firms can choose to report a combined statement of comprehensive income or as two separate statements.

Statement of Changes in Equity

This statement consolidates the amounts and sources of changes in equity investor’s investment in the firm over a period of time. Shareholder transactions, such as dividend payouts, and total comprehensive income affect the change in equity.

Statement of Cash Flows

The statement of cash flows links the cash balance from one period to the next and is divided into three sections:

• Operating Cash Flows: Cash effects of transactions involving the normal business of the firm.
• Investing Cash Flows: Cash flows resulting from the purchase or sale of long-term assets, such as property, equipment, subsidiaries, or investment assets.
• Financing Cash Flows: Cash flows from activities related to obtaining or repaying capital to be used in the business.

The sum of these three cash flows is the net cash flow for the period. When added to the cash balance from the previous period, it should equal the cash balance in the balance sheet at the end of the current period.

Footnotes and Management’s Discussion and Analysis (MD&A)

Besides the major financial statements, financial reports also include footnotes and the MD&A section.

Footnotes

Footnotes are an integral part of financial statements, providing additional information about the items presented. They can help analysts make a more in-depth analysis of the company’s financial performance. Footnotes should disclose:

• The basis of preparation (fiscal period covered, consolidated entities).
• Accounting methods, assumptions, and estimates used.
• Additional material information (business acquisitions or disposals, legal actions, employee benefit plans, contingencies, significant customers, related party sales, and segments of the firm).

Management’s Discussion and Analysis (MD&A)

Publicly-held companies typically include an MD&A section, where management discusses various issues of concern, such as the nature of the business, past performance, and future outlook. The requirements for the MD&A vary by jurisdiction, but in the United States, the SEC requires that it discusses trends, significant events, uncertainties, effects of inflation and changing prices, off-balance-sheet obligations, contractual obligations, accounting policies that require significant judgment, and forward-looking expenditures and divestitures.

And that wraps up this introduction to major financial statements! We will explore these topics in more detail in the upcoming lessons.