FINANCIAL STATEMENT

CFA LEVEL 1 ANALYSIS

CHAPTER 1
“CRAFTING YOUR
CFA TRIUMPH
WITH EFFECTIVE
SUMMARIES.”
CONCEPT NOTES
Introduction to Financial Statement Analysis
-Financial statement analysis 1
-Financial reporting 2

-Financial statements 3

-Financial statement footnotes 6

-Management’s discussion & analysis (MD&A) 6

-Audit & internal controls 7

-Proxy statement & earnings guidance 10

-Financial statement analysis framework 11

TABLE OF
CONTENTS
Introduction to Financial
Statement Analysis
What exactly is financial statement analysis?
Financial statement analysis is the process of examining a company's financial
reports, such as its income statement, balance sheet, and cash flow statement, to
evaluate its financial performance and make informed business decisions. This
analysis is crucial for investors, creditors, and internal management to assess the
financial health and stability of a company.
It involves dissecting a company's financial statements to assess its profitability,
liquidity, solvency, and overall financial strength. It provides insights into how
efficiently a company is generating profits, managing its debts, utilizing its
assets, and generating cash flow.

Let’s understand with a few real-life examples

Profitability Analysis: Investors may analyze a company's income
statement to determine its profitability. For instance, they might look at
metrics like the net profit margin (net income divided by total revenue) to
gauge how effectively a company turns its sales into profits. If a company
consistently maintains a high profit margin, it indicates strong profitability,
as exemplified by Apple Inc., which has historically maintained robust profit
margins due to its premium pricing strategy.
Liquidity Analysis: Creditors, such as banks, analyze a company's balance
sheet to assess its liquidity, i.e., its ability to meet short-term financial
obligations. They might examine the current ratio (current assets divided by
current liabilities) to evaluate this. Amazon, with its vast cash reserves can
easily handle short-term liabilities thus, reflecting strong liquidity.
Solvency Analysis: Companies seeking financing or investors often
examine the debt-to-equity ratio (total debt divided by shareholders' equity)
to assess solvency. Tesla Inc., for instance, has garnered attention for its
increasing debt levels in relation to equity, raising questions about its long-
term financial stability.

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 "Financial statement analysis is the X-ray of a
company's financial health, revealing its
strengths, weaknesses, and potential for
growth."

What is meant by financial reporting?

Financial reporting is the comprehensive process of disclosing a company's
financial information, performance, and position to external stakeholders. This
communication typically takes the form of financial statements, annual reports,
and regulatory filings, and it plays a pivotal role in the corporate world, shaping
investor confidence and facilitating informed decision-making.

How is financial reporting useful in real-life?

Investor Relations: Financial reporting serves as a vital bridge between
companies and their investors. It allows shareholders and potential
investors to assess a company's past performance, future prospects, and
overall financial health. For example, when Apple Inc. releases its annual
report and earnings statements, it influences investors' decisions to buy,
hold, or sell its stock.
Regulatory Compliance: In the corporate world, adherence to financial
reporting standards and regulations is not optional—it's a legal requirement.
Companies must comply with standards like Generally Accepted Accounting
Principles (GAAP) or International Financial Reporting Standards (IFRS) to
ensure transparency and accountability. Failure to do so can result in legal
penalties and a loss of investor trust.
Mergers and Acquisitions (M&A): When companies consider mergers,
acquisitions, or partnerships, accurate financial reporting is essential.
Potential partners or acquirers scrutinize a target company's financial
reports to assess its value, liabilities, and growth potential. For instance,
when Facebook acquired WhatsApp, both companies' financial reporting
played a pivotal role in determining the deal's worth.

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 “A notable example of poor financial reporting
causing a serious corporate problem is the
WorldCom scandal in 2002 which led to
bankruptcy and investor losses.”

What is a balance sheet?

A balance sheet is one of the fundamental financial statements used in
accounting to provide a snapshot of a company's financial position at a specific
point in time, typically at the end of an accounting period, such as a quarter or
year. It is called a balance sheet because it must adhere to the fundamental
accounting equation, which states that a company's assets must equal the sum of
its liabilities and shareholders' equity.
Primary components of a balance sheet are following:
Assets: Assets are what a company owns and can use to generate future
economic benefits. They are categorized into two subgroups:
Current Assets: These are assets that are expected to be converted
into cash or used up within one year or the normal operating cycle of the
business. Examples include cash, accounts receivable, and inventory.
Non-Current Assets (or Long-term Assets): These are assets that
are expected to provide benefits over a period longer than one year.
Examples include property, plant, equipment, and long-term
investments.
Liabilities: Liabilities are what a company owes to external parties. Like
assets, they are categorized into two subgroups:
Current Liabilities: These are obligations that are expected to be
settled within one year or the normal operating cycle of the business.
Examples include accounts payable, short-term loans, and accrued
expenses.
Non-Current Liabilities (or Long-term Liabilities): These are
obligations that extend beyond one year. Examples include long-term
debt, lease obligations, and deferred tax liabilities.

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 Shareholders' Equity: This represents the residual interest in the assets
of the company after deducting its liabilities. It is also known as "owner's
equity" or "net assets" and consists of common stock, retained earnings, and
additional paid-in capital.

What is meant by an accounting equation?

Accounting Equation: The accounting equation is the foundation of double-entry
accounting and represents the relationship between a company's assets,
liabilities, and shareholders' equity. It is expressed as:

Assets Liabilities Equity Capital

This equation ensures that a company's resources (assets) are financed either by
external parties (liabilities) or by the owners (shareholders' equity). It provides a
precise framework for recording and tracking financial transactions.

What is a statement of comprehensive income?

The statement of comprehensive income (also known as the income statement
or profit and loss statement) is a financial statement that provides a summary of
a company's revenues, expenses, gains, and losses during a specific period,
typically a fiscal quarter or year. Its primary purpose is to show how much profit
or loss a company has generated over that period. The statement of
comprehensive income helps stakeholders understand the company's
operational performance and profitability.

Statement of comprehensive income Vs Income statement

The income statement and statement of comprehensive income are often used
interchangeably, but they can be slightly different depending on accounting
standards. In general, both statements show a company's profitability, but the
statement of comprehensive income may include items not present on a
traditional income statement, such as unrealized gains and losses on
investments. The comprehensive income statement provides a more
comprehensive view of a company's financial performance.

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What is a statement of changes in owner’s equity?
The statement of changes in equity (also known as the statement of
shareholders' equity or statement of retained earnings) is a financial statement
that provides a summary of the changes in a company's equity accounts over a
specific period. It outlines how a company's equity has evolved due to various
factors, including net income or loss, dividends paid, stock issuances or
repurchases, and other comprehensive income items. Its primary purpose is to
track and explain the changes in a company's ownership interests or
shareholders' equity.

What is a statement of cash flows?

The statement of cash flows is another vital financial statement that provides a
summary of a company's cash inflows and outflows during a specific period. It is
categorized into three main sections: operating activities, investing activities,
and financing activities. The primary purpose of the statement of cash flows is to
show how a company generates and uses cash and cash equivalents, helping
stakeholders assess its liquidity and cash management.

How is cash flow statement different from income statement?

While the income statement reports accounting profits

Focus on and losses, the statement of cash flows focuses
cash exclusively on cash transactions. It tracks the movement
of cash into and out of a company.

The income statement records revenues and expenses

when they are earned or incurred, regardless of when
Timing
cash changes hands. In contrast, the statement of cash
flows tracks when cash is actually received or paid.

The income statement reflects a company's operational

performance, including non-cash items like depreciation
Scope
and amortization. The statement of cash flows excludes
these non-cash items.

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What is a financial statement footnote?
Financial statement footnotes, also known as financial statement disclosures or
notes to the financial statements, are an integral part of a company's annual or
quarterly financial reports. They provide additional information and
explanations to clarify and expand upon the data presented in the main financial
statements, which typically include the income statement, balance sheet, and
cash flow statement.
Here are few points why financial statement footnotes are important for
conducting financial statement analysis:
Clarification and Explanation: Footnotes provide detailed explanations
and clarifications about the accounting policies, assumptions, and
methodologies used in preparing the financial statements. This helps
analysts understand how certain numbers were arrived at and whether there
have been any significant changes in accounting methods or estimates.
Contingencies and Risks: Footnotes often disclose contingent liabilities,
pending lawsuits, and other potential risks that may not be readily apparent
from the main financial statements. This information is crucial for assessing
a company's potential financial exposures.
Accounting Changes: Footnotes disclose any changes in accounting
principles or practices, which can significantly impact the comparability of
financial statements over time. Analysts need to understand these changes
to make meaningful comparisons and evaluate trends.

What is management discussion & analysis (MD&A)?

Management's Discussion and Analysis (MD&A) is a section of a company's
annual or quarterly financial reports, such as its annual report or Form 10-K (in
the United States), where the management team provides a narrative discussion
and analysis of the company's financial performance, operations, and future
outlook. MD&A is a crucial part of financial reporting and plays a significant role
in financial statement analysis.
Here are some key points that are typically included in MD&A and why they are
essential for financial statement analysis:

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 Financial Performance Analysis: MD&A discusses the company's
financial performance over the reporting period. It provides insights into
factors affecting revenue, expenses, profitability, and overall financial health.
Analysts can assess trends in revenue growth, cost management, and
profitability ratios (e.g., gross margin, operating margin) to gauge the
company's financial stability and performance.
Liquidity and Capital Resources: MD&A outlines the company's
liquidity position and capital resources. This includes discussions about cash
flows, working capital management, debt obligations, and any significant
capital expenditures. Analysts can assess whether the company has
sufficient resources to meet its short-term and long-term obligations.
Critical Accounting Policies: MD&A typically highlights the company's
critical accounting policies, including estimates and assumptions used in
financial reporting. Understanding these policies is essential for analysts
because they can significantly impact the financial statements. Any changes
in accounting policies should be carefully considered for their implications.

“Management's Discussion and Analysis (MD&A)

provides the 'why,' 'how,' and 'what's next,'
offering investors a deeper understanding of the
company's financial narrative."

What is an audit?
An audit is a systematic examination and verification of a company's financial
statements, transactions, records, and internal controls by an independent and
qualified auditor or auditing firm. The primary purpose of an audit is to provide
an objective assessment of a company's financial information, ensuring that it is
presented fairly and accurately in accordance with generally accepted accounting
principles (GAAP) or International Financial Reporting Standards (IFRS) and
relevant regulatory requirements.
Audits are necessary for public companies to maintain financial transparency,
comply with legal and regulatory requirements, provide assurance to
stakeholders, and enhance investor confidence.

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What is a standard auditor’s opinion?
A standard auditor's opinion, also known as an auditor's report or audit opinion,
is a formal statement issued by an independent auditor or auditing firm after
conducting an audit of a company's financial statements. The auditor's opinion
provides an assessment of the fairness and accuracy of the financial statements
and communicates the results of the audit to the users of those financial
statements.
A standard auditor's opinion typically consists of three primary segments:
Management's Responsibility: This section outlines the responsibility
of the company's management for preparing the financial statements and for
maintaining internal controls to prevent and detect fraud and errors. It also
mentions that the auditor's responsibility is to express an opinion on the
financial statements based on the audit.
Auditor's Responsibility: The auditor's opinion describes the auditor's
responsibility, which is to obtain reasonable assurance about whether the
financial statements are free from material misstatement, whether due to
fraud or error. It explains that the audit involves assessing internal controls,
performing procedures to gather audit evidence, and evaluating the
appropriateness of accounting policies used.
Basis for Opinion: In this section, the auditor describes the procedures
performed during the audit, including examining evidence, assessing
internal controls, and evaluating accounting estimates. It also mentions that
the audit involves judgment and the risk of material misstatement.

“Independent auditors failed to detect the

issues at Enron, leading to a loss of investor
confidence and regulatory reforms in corporate
governance and auditing practices.

The standard auditor's opinion is a critical document that communicates the

auditor's assessment of the company's financial statements to various
stakeholders, including investors, creditors, regulatory authorities, and the
general public.

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What are different types of opinion given by an auditor?
Opinion is the central part of the auditor's report where the auditor provides
their opinion on the financial statements. There are several possible opinions:

Unqualified Opinion
This is the most common and desirable outcome. It means the auditor
believes the financial statements are presented fairly in all material
respects, in accordance with the applicable accounting standards.

Qualified Opinion
A qualified opinion is issued when the auditor believes that the financial
statements are generally presented fairly but has identified specific issues
or departures from GAAP that materially impact the statements. This
opinion is accompanied by a description of the issues.

Adverse Opinion
An adverse opinion is issued when the auditor believes that the financial
statements are not presented fairly and are materially misstated. This is a
serious and unfavorable opinion.

Disclaimer of Opinion
A disclaimer of opinion is issued when the auditor is unable to obtain
sufficient evidence to express an opinion due to significant limitations or
uncertainties in the audit process.

What are internal controls?

Internal controls are a system of policies, procedures, and practices
implemented within an organization to ensure the reliability of financial
reporting, compliance with laws and regulations, and the effectiveness and
efficiency of operations. These controls are designed to safeguard assets, prevent
fraud, and provide reasonable assurance that the organization's objectives are
met.

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How internal controls complement audit?
Audit Planning: Auditors use their understanding of the organization's
internal controls as a basis for planning the audit. They assess the
effectiveness of these controls to determine the extent of substantive testing
required during the audit.
Risk Assessment: Internal controls help auditors identify and assess risks
related to financial reporting, fraud, and compliance. They assist in
determining where weaknesses or deficiencies may exist, which informs the
audit approach.
Testing and Evidence: Auditors often rely on internal controls to test
transactions and balances. Effective internal controls provide evidence that
transactions are properly authorized, recorded accurately, and reported
correctly in the financial statements.
Fraud Detection: Internal controls are instrumental in detecting and
preventing fraud. Auditors assess the design and operation of internal
controls to identify areas vulnerable to fraudulent activities.

What is a proxy statement?

A proxy statement, in the context of a publicly traded company, is a formal
document that provides shareholders with essential information about matters
to be voted on at the company's annual general meeting (AGM) or special
shareholders' meeting. It serves as a critical communication tool between the
company's management and its shareholders, allowing shareholders to make
informed decisions about corporate governance, executive compensation, and
other significant issues.
The proxy statement typically includes details about director elections, executive
compensation packages, shareholder proposals, and other important agenda
items. Shareholders who are unable to attend the meeting in person can use the
proxy statement to vote on these matters by appointing a proxy to vote on their
behalf.
In essence, the proxy statement promotes transparency, accountability, and
shareholder participation in corporate decision-making processes.

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What is an earnings guidance?
Earnings guidance is a forward-looking financial estimate or projection provided
by a publicly traded company to inform investors and analysts about its expected
future financial performance. Typically issued on a quarterly or annual basis,
earnings guidance includes forecasts for key financial metrics such as revenue,
earnings per share (EPS), operating income, and other relevant financial
indicators.
Companies use earnings guidance as a means of setting expectations and helping
investors and analysts understand the company's outlook and potential
challenges or opportunities. Guidance can be either optimistic (positive outlook)
or pessimistic (cautious outlook) based on the company's assessment of market
conditions, internal factors, and anticipated business performance.
Investors often pay close attention to earnings guidance when making
investment decisions, and it can influence stock prices and market sentiment.
However, companies must exercise caution in providing accurate and
transparent guidance to avoid potential legal and regulatory issues.

What is a financial statement analysis framework?

The financial statement analysis framework is a structured approach that
financial analysts and investors use to assess and evaluate a company's financial
performance and condition based on its financial statements. This framework
helps in extracting meaningful insights from the income statement, balance
sheet, and cash flow statement.
The framework typically consists of six key steps:
State the Objective and Context: Before diving into financial statement
analysis, it's crucial to establish the purpose and context for the analysis.
This step involves defining the specific objectives of the analysis. Are you
evaluating a company's financial health for investment purposes, assessing
credit risk as a lender, or analyzing performance for strategic decision-
making? Understanding the context and goals of the analysis helps guide the
entire process.

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Gather Data: Once you've defined your objectives, gather the necessary
data. In financial statement analysis, this involves obtaining the company's
financial statements, which include the income statement, balance sheet,
and cash flow statement. You may also need supplementary information,
such as notes to the financial statements and management's discussion and
analysis (MD&A).
Process the Data: After collecting the financial data, it needs to be
organized, standardized, and prepared for analysis. This step includes tasks
like normalizing financial statements to remove one-time items, converting
foreign currency figures to a common currency, and adjusting for any
changes in accounting policies or standards. The goal is to ensure the data is
consistent and comparable.
Analyze and Interpret the Data: This is the heart of financial statement
analysis. In this step, you calculate and interpret various financial ratios,
trends, and key performance indicators (KPIs). You assess the company's
liquidity, profitability, solvency, and efficiency by examining metrics such as
the current ratio, return on equity, debt-to-equity ratio, and operating
margin. Interpretation involves comparing the company's financial results to
industry benchmarks and historical performance, identifying strengths and
weaknesses, and assessing potential risks.
Report the Conclusions or Recommendations: After analyzing the
data, you draw conclusions and make recommendations based on your
findings. For example, you might conclude that the company has strong
liquidity but needs to address declining profitability. Recommendations
could include improving cost management or diversifying revenue sources.
It's crucial to communicate your conclusions clearly and provide supporting
evidence.
Update the Analysis: Financial statement analysis is not a one-time
activity. To stay relevant and make informed decisions, you should regularly
update your analysis. Financial conditions can change due to economic
factors, industry trends, or company-specific developments. Keeping the
analysis up-to-date ensures that you have the most current information for
decision-making.

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CFA L1 Notes

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Published: October 2023