Financial Statement Analysis

FSA Framework: 6 Phases (order, key sources, key output)

1) Articulate purpose & context — sources: analyst's function, client/supervisor input, institutional guidelines; output: purpose statement, questions, report format/timetable. 2) Collect data — sources: financial statements, management/industry discussions, site visits; output: usable financial data, questionnaires. 3) Process data — sources: data from Phase 2; output: adjusted financial statements, common-size statements, ratios/graphs. 4) Analyze/interpret data — sources: input + processed data; output: analytical results, forecasts, valuations. 5) Develop & communicate conclusions — sources: analytical results, institutional report guidelines; output: report answering Phase 1 questions + recommendation. 6) Follow-up — sources: periodic repeat of prior phases; output: comparison of actual vs. expected, revised forecasts, updated reports.

What is the "top-down approach" used when collecting economic/industry data (Phase 2)?

Three-step macro-to-micro sequence: (1) assess the macroeconomic environment (growth, inflation), (2) assess industry prospects given that macro environment, (3) assess company prospects given the industry and macro environment.

What is a common-size financial statement, and why is it produced in Phase 3 (Process Data)?

A statement where line items are scaled to percentages (e.g. % of sales, % change from prior year) to make comparison across companies or time periods easier — alongside ratios, it's a key output of the data-processing phase.

What is the role of financial statement analysis, and why don't company managers rely on it exclusively for their own decisions?

Role: to use financial reports, combined with other information, to evaluate a company's past, current, and potential future performance and financial position, for making investment, credit, and other economic decisions. Managers also perform financial analysis but don't rely on it exclusively, since they have access to nonpublic internal information that external analysts don't.

What kinds of decisions do analysts use FSA for, what two performance factors do they focus on, and how are earnings used directly in valuation?

Decisions: equity investment inclusion, valuation for a recommendation, creditworthiness/loan terms, debt/credit ratings, venture capital or private equity investment, M&A evaluation. Focus: profitability and ability to generate positive cash flow. Earnings are used directly in valuation via P/E comparisons to peers or as inputs into DCF models.

What is IOSCO, and what are its three core objectives of securities regulation?

Although not itself a regulatory authority, IOSCO's ordinary members (national securities regulators) regulate over 95% of the world's financial capital markets. Its three core objectives: (1) protecting investors, (2) ensuring markets are fair, efficient, and transparent, and (3) reducing systemic risk.

What are the two IOSCO "Principles for Issuers" that relate directly to financial reporting?

(1) There should be full, accurate, and timely disclosure of financial results, risk, and other information material to investors' decisions. (2) Accounting standards used by issuers should be of a high and internationally acceptable quality.

What are the three key US statutes enforced by the SEC relevant to financial reporting, and what does each do?

Securities Act of 1933 — specifies info investors must receive when securities are sold, prohibits misrepresentation, requires initial registration of public offerings. Securities Exchange Act of 1934 — created the SEC, gave it authority over the securities industry, and requires periodic reporting by public companies. Sarbanes–Oxley Act of 2002 — created the PCAOB, addresses auditor independence, requires executive certification of financial reports, and requires management reporting on internal control effectiveness.

What are the main periodic/registration SEC filings analysts use, and what does each contain?

Securities Offering Registration Statement — filed under the 1933 Act when new securities are offered. Forms 10-K/20-F/40-F — comprehensive annual filings (US/other non-US/certain Canadian registrants) with audited financials, MD&A, and auditor's report. Annual Report — not an SEC requirement, more marketing-oriented than the 10-K. Proxy Statement/Form DEF-14A — filed before shareholder meetings; covers voting matters, ownership, director bios, executive comp. Forms 10-Q/6-K — quarterly (US)/semiannual (non-US) interim reports with unaudited financials.

What are the main event-driven or ownership-related SEC filings, and what does each report?

Form 8-K/6-K (current report) — reports material events between periodic filings (acquisitions/disposals, accountant changes, governance changes, Reg FD disclosures). Forms 3, 4, 5 — beneficial ownership reporting for directors/officers/10%+ holders (initial, changes, annual). Form 144 — notice of a proposed sale of restricted securities by an affiliate. Form 11-K — annual report of employee stock purchase/savings plans.

How does IFRS get endorsed for use by EU-listed companies, and what are the ESC and ESMA?

Since 2005, consolidated accounts of EU-listed companies use IFRS. Endorsement process: IASB issues a standard → EFRAG advises the European Commission → Standards Advice Review Group opinions that advice → Commission drafts an endorsement regulation → Accounting Regulatory Committee votes → if favorable, goes to the European Parliament and Council for approval. The European Securities Committee (ESC) advises the Commission on securities policy; the European Securities and Markets Authority (ESMA) is the EU's cross-border market supervisor (one of three European supervisory authorities, alongside banking and insurance).

What do financial statement notes typically disclose, and why does accounting flexibility create challenges for analysts?

Notes disclose the basis of preparation (fiscal year, framework used, currency/rounding, consolidation basis) plus accounting policies, methods, and estimates, and typically cover segment reporting, business acquisitions/disposals, contractual obligations (on/off-balance-sheet), financial instruments and risks, legal proceedings, related-party transactions, and subsequent events. IFRS/US GAAP allow flexibility in policies/methods/estimates to fit diverse businesses, but this reduces comparability across companies, so analysts must understand the choices made to adjust appropriately.

What defines an "operating segment," and when must it be separately reported?

An operating segment engages in activities that may generate revenue/expenses, has results regularly reviewed by senior management, and has discrete financial information available. It's reportable if it represents 10%+ of combined segments' revenue, assets, or profit (profit test based on absolute values). If reportable segments' combined external revenue is under 75% of total company revenue, more segments must be added until that threshold is met.

What must be disclosed in the notes for each reportable segment?

Revenue (split between external and intersegment); a measure of profit or loss; assets and liabilities (if reviewed by the chief decision maker); interest revenue and expense; cost of PP&E and intangible assets acquired; depreciation and amortization; other non-cash expenses; income tax expense/income; and share of profit/loss from equity-method investments — plus a reconciliation of segment totals to the consolidated financial statements.

What is MD&A/management commentary, and what are its key content requirements?

A narrative discussion by management of the business, past results, and outlook (typically unaudited, except in Germany where it's audited). The IASB's Management Commentary framework identifies 5 elements: nature of the business, management's objectives/strategies, significant resources/risks/relationships, results of operations, and critical performance measures. The US SEC additionally requires discussion of favorable/unfavorable trends, liquidity/capital resource issues, effects of inflation, off-balance-sheet obligations and contractual commitments, and critical accounting policies.

Why do audits provide "reasonable" rather than "absolute" assurance, and what are the four types of audit opinion?

Audits use sampling techniques and rely on estimates/assumptions, so they cannot guarantee absolute accuracy — only reasonable assurance that statements are free of material misstatement. Opinion types: unqualified/clean (fairly presented — what analysts want to see), qualified (a scope limitation or exception exists), adverse (statements materially depart from standards), and disclaimer of opinion (auditor unable to issue an opinion).

What are Key Audit Matters (international) / Critical Audit Matters (US) in an audit report?

Matters that involved the auditor's most challenging, subjective, or complex judgment, or that carry a higher risk of misstatement or significant management judgment — disclosed in the audit report, but not necessarily the matters most important to analysts and investors.

What are the major differences between US GAAP and IFRS (developer, basis, interest paid, inventory valuation, development costs, inventory write-down reversal)?

Developed by: FASB (US GAAP) vs. IASB (IFRS). Based on: rules (GAAP) vs. principles (IFRS). Interest paid: operating activities only (GAAP) vs. financing or operating (IFRS). Inventory valuation: FIFO/LIFO/weighted average (GAAP) vs. FIFO/weighted average only, no LIFO (IFRS). Development costs: expensed (GAAP) vs. capitalized if conditions are met (IFRS). Reversal of inventory write-down: prohibited (GAAP) vs. permissible if conditions are met (IFRS).

What are the four categories of information sources analysts use beyond an issuer's regulatory filings, with examples of each?

Issuer sources — earnings calls, investor day presentations/events, press releases, speaking with management/IR, visiting the company's website or properties. Public third-party sources — free whitepapers/analyst reports, government/organization economic or industry indicators, general and industry-specific news outlets, social media. Proprietary third-party sources — sell-side analyst reports and credit rating agencies, data platforms (e.g. Bloomberg), industry-specific consultancy data. Proprietary primary research — surveys, conversations, product comparisons, and other studies the analyst commissions or conducts directly.