An Introduction to Financial Statement Analysis

What is Financial Statement Analysis?

Financial reporting is the way companies show their financial performance to investors, creditors, the market, and other stakeholders. The objective is to provide useful information on changes in a firm’s performance and financial position in order to hep those potentially interested in “providing resources” to the company make informed decisions.

Financial statement analysis is the act of using financial reports and other information to make economic decisions related to that company such as buying/selling equity or lending money. Analysts do this by comparing past performance with its current financial position.

What are the 3 assumptions underlying accounting statements?

  1. The company will continue to operate (going-concern assumption)
  2. Revenues are reported as they are earned within the specified accounting period
  3. Expenses should match generated revenues within the specified accounting period[1]

What are the 6 basic steps in financial statement analysis?

  1. State the objective & contextWhat questions want answered
  2. Gather the data – Financial statements and other relevant data
  3. Process the data – Adjust FS as needed, calculate ratios, prepare exhibits
  4. Analyze & interpret the dataUse data to answer questions from #1
  5. Report the conclusions and recommendations
  6. Update the analysis

Cash-Basis vs. Accrual Accounting

Cash-basis and accrual accounting are the two main accounting methods. They are also very different.

  • The cash-basis accounting method recognizes income and expenses when they are made, i.e. when cash is deposited in the bank and when payments are made 
  • Accrual accounting recognizes revenue in the period when it is earned, i.e. when the firm provides a product or service to a customer regardless of when they are actually paid. Expenses are recorded when they are incurred not when they are actually paid.

On the CFA Level 1 exam (really on L2 as well) assume that all questions refer to accrual accounting unless specifically told it is using a cash basis method.

Components of the Balance Sheet

The balance sheet, also known as the statement of financial position (or condition), reports a firm’s financial position at a specific point in time. It has 3 elements: 

  • Assets – The economic resources controlled by the firm
  • Liabilities – The current or estimated liabilities of the firm, i.e. the amount owed to lenders and other creditors
  • Owners equity – This is the net assets of a firm after subtracting its liabilities, i.e. the residual. It is the assets that would be left after all the creditors are paid.

The Fundamental Accounting Equation

The balance sheet leads us to THE the fundamental accounting equation: 

Assets = Liabilities + owners equity

The equation can be rearranged to solve for any of the other variables. You may find it most intuitive when it is shown as:

Owners Equity = Assets Liabilities

You must know and remember the equation, it is useful in countless FSA problems. 

Components of the Income Statement

The Income statement, also called the statement of operations or the profit and loss statement, shows the financial performance of a firm over a period of time. In other words it tells us if the firm made or lost money in the form of net income. It consists of revenues, expenses, and gains/losses (G/L). 

  • Revenue – Inflows from the firm’s central operations, i.e. delivering goods or services
  • Expenses – Outflows relating to the firm’s revenue producing activities, results in assets ↓ , liabilities ↑
  • Other income – Gains and losses arising from anything not related to the ordinary course of business

Note the statement of comprehensive income reports all changes in equity except for shareholder transactions (stock buyback, issuance, and dividend payments). Under IFRS the income statement and comprehensive income can be combined. Under GAAP the statement of comprehensive income can be reported in the statement of shareholders’ equity.

Statement of Changes in Equity

The statement of changes in equity reports the amount and sources of change in equity investors’ investment in the firm over a period of time. 

Components of the Cash Flow Statement

The cash flow statement reports a company’s cash receipts and payments. It links the firm’s net income to cash inflows/outflows and shows how  It consists of:

  • Operating cash flows – CFs from transactions involving the normal business of the company
  • Financing cash flows – CFs from the issuance or retirement of debt and equity, including dividends
  • Investing cash flows
  • CFs resulting from sale or acquisition of PPE
  • CFs from a subsidiary or investments in other firms
  • CFs from securities or investments

In addition to the major financial statements themselves, management always releases both notes and a discussion of the firm's performance. Understanding both of these supplementary sources is essential to being able to interpret reported results. 

Financial Statement Notes and Management Commentary

An analyst should not just rely on the info in a financial statement. He or she needs to understand the reporting choices and estimates used by management to gauge the impact of accruals, adjustments, assumptions and how well the FS’s reflect the company’s true performance. They also need to be vigilant for any deliberate attempts by management at manipulating reporting of the firm’s financial performance.

This info is found in the footnotes of a firm’s financial statements. They typically disclose:

  • The basis of the presentation including the fiscal period covered & which entities are included
  • The accounting methods, assumptions, and estimates used
  • Info on business acquisitions, divestitures, legal actions, contingencies and commitments, significant customers, and employee benefit plan info

Management commentary, or management’s discussion and analysis (MD&A), is also an incredibly useful part of the annual report as it is where management talks about the business’s strategic considerations, past performance, & future outlook. It can include discussion of capital resources, liquidity, significant trends, extra-ordinary items, and discontinued operations.

In the U.S. mandated sections of the MD&A include:

  • Impact of off-balance sheet obligations and contractual commitments
  • Discussion of inflation and changing prices if material to the business
  • Accounting policies requiring significant judgement by management
  • Forward looking expenses and divestitures

Putting the Pieces Together - Supplementary Info

A careful examination of a firm and its future prospects is definitely rooted in the financial statements. But going back to the idea of mosaic theory, an analyst should seek to put together as many disparate pieces of information in order to draw a comprehensive and unbiased conclusion.

Other information an analyst should look at includes: 

  • Quarterly and semi-annual reports (which may not be audited)
  • Proxy statements – These are issued to shareholders when something requires a shareholder vote, usually regarding board members, compensation (stock options), management qualifications
  • Corporate reports & press releases
  • Earnings guidance if released ahead of the financial statements
  • Economic & Industry conditions
  • Comparisons against competitors

This should serve as a solid summary of the CFA Institute's Level 1 Reading #22, "Financial Reporting and Analysis: An Introduction."

[1] Note the timing and method of recording revenues and expenses can impact the comparability of financial statements across firms