Level I CFA: Financial Statement Analysis: An Introduction

introduction to financial statement analysis in this reading we'll talk about the roles of financial statement analysis then we will discuss the primary financial statements such as the balance sheet the income statement the cash flow statement as well as other information sources that are used by financial analysts and then we will discuss the financial statement analysis framework financial reports are one of the most important sources of information available to a financial analyst and therefore it is necessary that a financial analyst have a strong understanding of the information provided in a company's financial reports the associated notes and supplementary information rules of financial statement analysis let us understand the distinction between financial reporting and financial statement analysis with financial reporting companies provide information on performance financial position and changes in financial position the report on performance comes through a income statement the report on financial position is through the balance sheet and changes in financial position generally are through the statement of changes in stockholders equity the information that comes out of financial reporting is what feeds the financial statement analysis process and not only does financial statement analysis use the reports that come from here but other information is also necessary we'll talk about this in more detail later but essentially what the analyst needs to do is evaluate the past present and future performance of a company or subsidiary obviously the analyst studies the past and present performance through financial reports and then needs to assess the future performance and then make a investment decision which might either be a credit decision in terms of whether or not to lend to the company or whether or not to purchase shares in the company when we talk about performance there are several areas that we need to consider such as profits profitability which is a ratio of profits to either investment or profits to revenue we need to consider cash flows the liquidity of a company which is an indication of how able a company is to meet short-term obligations and solvency which is the ability of a company to meet long-term obligations these are areas that we will discuss in a lot more detail later in the course here are the four major financial statements the income statement balance sheet cash flow statement and statement of changes in owner's equity let us look at a simple version of the income statement over here later in the course there is a long reading on the income statement so obviously details will be covered there but very briefly the income statement is for a period in this particular case we are considering the year ending 31st december 2012.

so this is the income statement for the entire 2012. we have a revenue number which is the total money that came in we subtract the expenses then subtract taxes and end up with the net income the income statement is also called the statement of operations it is also called the profit and loss statement or the pnl statement you also need to recognize the fact that there is a more comprehensive definition of income and that is covered in the statement of comprehensive income i will not cover comprehensive income at this stage i will cover it later when we discuss the income statement and balance sheet but just recognize that there is also a definition of income that goes beyond the regular net income here is a simplistic version of a balance sheet note that the balance sheet is depicted on a particular day here we are looking at a balance sheet as of 31st december 2012.

This is also called the statement of financial position or the statement of financial condition it shows all the assets of the company both tangible and intangible assets the liabilities short term and long term and then stockholders equity this is the cash flow statement which is also for a given period this cash flow statement tells us what money has flowed in and what has flowed out the cash flow statement is divided into three parts operating activities investing activities and financing activities the financial statement notes and supplementary schedules provide a tremendous amount of additional information that is not explicitly available in the balance sheet income statement or cash flow statement and examples of what you will see in the notes and supplementary schedules is given right here if you have not done so before i would strongly encourage you to look at the financial statements of a few companies management discussion and analysis also called md a essentially provides a discussion and analysis regarding a company's future outlook and prospects this can be thought of as subjective information where management is presenting its view and interpretation of the data that it has reported and then also describing the future outlook management should establish and maintain adequate internal control over financial reporting the objective is to provide reasonable assurance regarding the reliability of financial reporting essentially this means that when a company is preparing financial reports the company should put in place processes to ensure that the financial reports adequately reflect the economic reality of the company once a company has prepared its financial reports and the reports have been audited internally or or have been through the appropriate internal control process then the financial reports need to be audited what this means is that a independent accounting firm examines the financial statements and then expresses a opinion through a audit report the audit report needs to follow a particular format but what we need to recognize is that the audit report will give one of three opinions either a qualified unqualified or adverse opinion a unqualified opinion is what we would like to see this is where the accounting firm provides reasonable assurance that the financial statements are fairly presented a qualified opinion is where the accounting firm says that there are some misstatements or exceptions to accounting standards and uh adverse opinion is where the accounting firm is saying that the financial statements are materially misstated the audit report also includes a discussion of key audit matters key audit matters are defined as issues that the auditor considers to be most important such as those that have a high risk of misstatement involve significant management judgment or report the effects of significant transactions during the period now the term key audit matters is used in an international context in the u.s context the corresponding term is critical audit matters critical audit matters are defined as issues that involve especially challenging subjective or complex auditor judgment other sources of information include interim financial reports and proxy statements generally companies present interim reports every quarter and these contain the four key financial statements along with footnotes interim financial reports are generally not audited proxy statements are distributed to shareholders and describe matters that are to be put to a vote and an example would be voting for a new director the proxy statements also contain other useful information such as management and director compensation stock performance and potential conflicts of interest between management board and shareholders financial statement analysis framework this is perhaps the most testable part of the reading imagine you are a financial analyst what we are going to discuss here is the framework which is recommended by the cfa institute the first phase is to articulate the purpose and context based on your function client input and organizational guidelines just at a high level if you are a equity analyst looking for a long-term investment your purpose will be very different from somebody else who is a credit analyst looking to make a short term debt based investment so before you get into the details of your analysis you need to clearly articulate your purpose your objective and document what your objective is document the questions that need to be answered document the ultimate content of the report so you need to be clear what your report will eventually contain you should also document the timeline and budget so this is phase one of your analysis in phase two you collect data the most important information is typically the financial statements or financial reports you also collect other financial data industry and economic data you might have discussions with management suppliers customers and competitors so you collect this information and organize it your output here consists of the financial statements you've collected any financial tables that you create and the questionnaires that you create through this process you then process the data and the output from this exercise would be adjusted financial statements common sized statements which we will discuss later ratios graphs and forecasts imagine that you are analyzing three different auto companies in different parts of the world and they follow slightly different accounting standards which we will talk about in the next reading in order to compare these companies you need to make adjustments to the financial statements so that you can make apples to apples comparison this is called processing the data once the data has been processed you analyze and interpret the data and come up with your analytical results and finally you develop and communicate your conclusions and recommendations if you are conducting a analysis for whether or not to make a long-term equity investment your recommendation would be whether to buy or not to buy in other words whether to make the investment or not obviously your recommendation needs to be justified so you create the report which answers the questions that you listed in phase one given that you are making a long-term investment decision you should periodically follow up because circumstances change so every quarter as an example you might reconsider the situation and update recommendations or update your recommendation if necessary that's the end of this brief reading i will summarize the most important points first you need to understand the distinction between financial reporting and financial analysis financial reporting is about looking at existing and past data related to a company and then reporting against that information financial analysis is a much broader field which looks at financial reports as well as other information to assess whether or not to make a investment there are four key financial statements the income statement balance sheet cash flow statement and statement of changes in shareholder equity these four statements are backed up by a tremendous amount of information in the footnotes and supplementary schedules an audit report is important because this represents a independent third party's view on the financial reports that have been presented by the company and finally you need to be on top of the financial statement analysis framework that we just talked about this perhaps is the most important item from a testability perspective read the summary in the curriculum related to this reading it's very good review the learning objectives and make sure that you can say something sensible about every single learning objective the examples within the curriculum are few and they are somewhat complicated if you don't have time to completely understand them that's okay but if you go through them that is a bonus do the practice problems at the end because they are extremely good they are relatively simple but a reasonable indication of what you might see on the exam unfortunately there are not too many questions at the end so you will have to practice questions from other sources as well that is it for this reading

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