CFA L1 – Financial Statement Analysis Comprehensive Bullet Notes

Introduction to Financial Statement Analysis

• Financial-statement-analysis framework (6 iterative steps)
  • Determine purpose & context
  • Collect data (statements, management discussions, site visits)
  • Process data (ratios, growth, common-size, statistics)
  • Analyze/interpret ⇒ conclusions & recommendations
  • Develop/communicate conclusions (separate fact vs. opinion)
  • Follow up/monitor
• Roles of analysis
  • Evaluate performance/position for decisions: equity, credit, mergers, VC/PE, past-debt rating, portfolio advice, loan underwriting
• Key information sources
  • Regulatory filings (SEC, IOSCO, ESMA, etc.)
  • Financial-statement notes & supplemental schedules (policies, subsequent events, off-B/S, segment data ≥10 % rev./assets/profit and ≥75 % ext. rev.)
  • Management commentary (MD&A) – unaudited, required topics per IASB & SEC
  • Audit reports – unmodified vs. qualified/adverse/disclaimer; reasonable assurance; internal-control opinion (SOX)
  • Monitoring alternative reporting systems (IFRS v. US GAAP) & emerging standards
  • Other info: earnings calls, press releases; third-party public/proprietary; primary research

Analyzing Income Statements

• Revenue recognition – 5-step converged model
  1 Identify contract 2 Identify distinct performance obligations 3 Determine transaction price 4 Allocate price to obligations 5 Recognize revenue when obligation satisfied (transfer of control; collectability probable)
  • “Principal vs. Agent” example shows lower sales but higher margins when agent; affects common-size/ratios.
  • Long-term contracts → %-of-completion if criteria met (IFRS 15). Example: 60 % costs ⇒ recognize 60 % revenue & profit.
• Expense recognition
  • Match with associated revenues, expense as incurred, or capitalize then depreciate/amortize.
  • Capitalize interest on self-constructed assets: Asset for own use → depreciation; asset for sale → COGS; cash outflow $\text{CFI}$.
  • Capitalize software dev. costs after technological feasibility.
  • Estimates (bad-debt %, warranty %, useful lives) must be analysed YOY & peer.
• Capitalizing vs. expensing illustration (CAP Inc. vs. NOW Inc.)
  • Capitalization front-loads assets/CF, smooths earnings; immediate expensing depresses early profit but converges in cash.
• Non-recurring items
  • Unusual/infrequent disclosed separately; discontinued operations shown net of tax below continuing ops; assets & liabilities classified “held for sale”.
  • Changes in accounting policy (prospective/retrospective) vs. estimates (always prospective).
  • Analyst removes one-offs to improve forecasts.
• Earnings Per Share
  • Basic EPS $\displaystyle \frac{\text{NI} - \text{Pref Divs}}{\text{Weighted Avg Shrs}}$
  • Diluted EPS: adjust numerator (interest saved, pref. divs.) & denominator for potential shares; ignore antidilutive.
  • Options/Warrants → Treasury Stock Method (assume exercise, repurchase at avg. market price).
  • Required to present EPS on NI and on continuing operations.
• Income-statement analysis tools
  • Common-size (% of sales)
  • Profitability ratios: $\text{Gross Margin}=\frac{\text{GP}}{\text{Sales}},\; \text{Net Margin}=\frac{\text{NI}}{\text{Sales}}$

Analyzing Balance Sheets

• Intangible assets
  • Recognize identifiable, non-monetary assets w/o physical substance.
  • IFRS: cost or revaluation; US GAAP: cost.
  • Finite life ⇒ amortize + impairment review; indefinite ⇒ no amortization, annual impairment test.
  • Internally generated: IFRS capitalizes development (if criteria), expenses research; US GAAP expenses R&D.
  • Analysts often compute “tangible book” (exclude intangibles, goodwill).
• Goodwill
  • $\text{Goodwill}=\text{Purchase Price}-\text{FV(net identifiable)}$; capitalize, test annually for impairment; not amortized.
  • Analysts may remove goodwill and impairment charges.
• Financial instruments (assets)
  • IFRS categories: Amortized Cost, FV OCI, FV P&L (US GAAP: HTM/AFS/Trading + all equity FV P&L).
  • Measurement drives where unrealized gains/losses appear.
• Non-current liabilities
  • Financial liabilities at amortized cost unless trading/hedged/derivative.
  • Deferred-tax liabilities arise from temporary differences.
• Common-size balance sheet & ratios
  • Vertical: % of total assets.
  • Liquidity: $\text{Current}=\frac{\text{CA}}{\text{CL}},\;\text{Quick}=\frac{\text{Cash+MS+AR}}{\text{CL}},\;\text{Cash}=\frac{\text{Cash+MS}}{\text{CL}}$
  • Solvency: $\text{Debt/Equity}=\frac{\text{Total Debt}}{\text{Equity}},\;\text{Financial Leverage}=\frac{\text{TA}}{\text{TE}}$

Cash-Flow Statement Analysis (Parts I & II)

• Linkages: Every cash-flow line ties to changes in B/S accounts and I/S items (inventory purchases, depreciation, borrowing, deferred revenue examples).
• Preparation methods
  • Direct: list cash receipts/payments (customers, suppliers, wages, etc.).
  • Indirect: NI ± non-cash + working-capital changes.
  • Conversion indirect→direct: disaggregate NI, remove non-cash, adjust for WC.
• GAAP vs. IFRS classification
  • US GAAP: Interest Received → CFO; Interest Paid → CFO; Dividends Received → CFO; Dividends Paid → CFF.
  • IFRS options: interest/dividends received in CFO or CFI; interest/dividends paid in CFO or CFF; bank overdrafts part of cash.
• Free cash flow measures
  • $\text{FCFF}=\text{NI}+\text{NCC}+\text{Int}(1-\tau)-\text{FCInv}-\text{WCInv}$
  • $\text{FCFE}=\text{NI}+\text{NCC}-\text{FCInv}-\text{WCInv}+\text{Net Borrowing}$ or $\text{FCFE}=\text{CFO}-\text{FCInv}+\text{Net Borrowing}$
• Cash-flow ratios
  • Performance: $\frac{\text{CFO}}{\text{Revenue}},\;\frac{\text{CFO}}{\text{Avg Assets}},\;\text{CFO/share}$
  • Coverage: $\frac{\text{CFO}}{\text{Debt}},\;\frac{\text{CFO}+\text{Int}+\text{Tax}}{\text{Interest}}$ etc.

Inventories

• Lower-of-Cost and NRV (IFRS) / lower-of-cost-or-market (US GAAP)
  • Write-down ⇒ ↓assets, ↓equity, ↑expense; cannot reverse under US GAAP except when not LIFO/Retail.
  • Ratio impacts: liquidity, solvency, profitability negative; initial write-down may improve activity ratios.
• Cost-flow methods & inflation
  • FIFO: oldest to COGS ⇒ higher profit & inventory in inflation; LIFO opposite.
  • Analysts adjust for LIFO reserve when comparing companies.
• Disclosures: method, carrying amounts by category, write-downs & reversals, inventory pledged, LIFO liquidation gains (US).

Long-Term Assets

• Impairment testing
  • IFRS one-step: if \text{CV} > \text{Recoverable Amount}=\max(\text{Value in Use},\;\text{FV - costs to sell}).
  • US GAAP two-step: 1) Undiscounted cash-flows < CV? → impaired; 2) loss = CV – fair value.
  • Reversals allowed under IFRS (except goodwill); US GAAP only for held-for-sale.
• Derecognition
  • Gain/Loss = Proceeds – NBV (I/S); cash to $\text{CFI}$.
  • Asset exchanges: record at FV asset received/given.
• Disclosures enable analyst ratios
  • Fixed-asset turnover $=\frac{\text{Revenue}}{\text{Avg Net PPE}}$
  • Asset-age: $\frac{\text{Accum Dep}}{\text{Annual Dep}}$; total life $=\frac{\text{HC PPE}}{\text{Annual Dep}}$.

Topics in Long-Term Liabilities & Equity

• Leases (IFRS): all lessee leases on B/S.
  • Recognize Right-of-Use Asset and Lease Liability = PV future payments (discount @ implicit or incr. borrowing rate).
  • I/S: interest + amortization; CF: principal → CFF, interest → CFO/CFF.
  • US GAAP: finance vs. operating; operating shows single lease expense & CFO outflow but still has ROU & liability.
• Lessor accounting: finance lease derecognize asset, recognize receivable; operating lease keep asset, book straight-line income.
• Employee compensation
  • Defined-contribution: expense = cash contribution.
  • Defined-benefit: net pension asset/liability = PV obligation – FV plan assets; service cost & net interest in I/S, remeasurements in OCI (IFRS) or amortized (US GAAP).
  • Share-based comp: expense FV at grant over vesting; options valued via option-pricing model; dilutive to EPS.
• Disclosures: maturity analysis of leases; pension assumptions; option roll-forwards.

Income Taxes

• Key terms
  • Accounting profit vs. taxable income; taxes payable (current) vs. tax expense $=\text{Taxes Payable}+\Delta\text{DTL}-\Delta\text{DTA}$.
  • Temporary differences ⇒ DTL/DTA: $\text{DTL}=\text{TD} \times \tau$.
  • Valuation allowance (US GAAP) or write-down (IFRS) if DTA not realizable.
• Tax rates
  • Statutory = legal rate; Effective $=\frac{\text{Tax Expense}}{\text{Pretax Income}}$; Cash $=\frac{\text{Taxes Paid}}{\text{Pretax}}$.
  • Differences arise from credits, non-deductible expenses, foreign ops, etc.

Financial Reporting Quality (FRQ)

• Two dimensions
  • Reporting quality (faithful, relevant)
  • Quality of reported results (sustainable earnings, adequate ROIC)
• Spectrum ① GAAP & high quality → ⑥ fictitious.
  • Conservative vs. Aggressive accounting affects timing of recognition.
  • Motivations: beat forecasts, bonuses, covenants; conditions: opportunity, pressure, rationalization (fraud triangle).
• Disciplinary mechanisms: market forces, regulators, audits, internal controls, covenants – all with limitations.
• Presentation choices: non-GAAP measures (EBITDA, EBITDAR, etc.) must be reconciled (SEC/IFRS guidance).
• Managerial methods to manage numbers: early shipment, channel stuffing, cookie-jar reserves, big-bath, capitalization policy, pension assumptions, related-party deals, CFO manipulation (delayed payables, IFRS classification choices).
• Warning signs: rising DSO, inventory build, CFO < NI, frequent one-offs, 4Q surprises, opaque disclosures, complex orgs.

Financial Analysis Techniques

• Purpose of ratio analysis: comparability across size, time, currency; identify trends; but subject to GAAP choices & judgment.
• Activity ratios (efficiency)
  $\text{Inventory Turnover}=\frac{\text{COGS}}{\text{Avg Inv}},\; \text{DOH}=\frac{365}{\text{InvTO}}$
  $\text{Receivables Turnover}=\frac{\text{Sales}}{\text{Avg AR}},\; \text{DSO}=\frac{365}{\text{RecTO}}$
  $\text{Payables Turnover}=\frac{\text{COGS}}{\text{Avg AP}}$
• Liquidity ratios: current, quick, cash; defensive-interval $=\frac{\text{Cash+MS+AR}}{\text{Daily Cash Exp}}$; cash-conversion cycle $=\text{DOH}+\text{DSO}-\text{DP}$.
• Solvency ratios: debt/asset, debt/capital, debt/equity, financial leverage, interest coverage $=\frac{\text{EBIT}}{\text{Interest}}$, fixed-charge coverage.
• Profitability ratios: margins, ROA, ROE, ROIC.
• DuPont decompositions
  • 2-step $\text{ROE}=\text{ROA}\times\text{Leverage}$
  • 3-step $\text{ROE}=\text{Net Margin}\times\text{Asset Turnover}\times\text{Leverage}$
  • Extended 5-factor adds tax burden, interest burden.
• Analysis techniques: vertical & horizontal common-size, cross-sectional, trend, regressions, graphs.

Introduction to Financial-Statement Modeling

• Sales-based pro-forma process
  1 Forecast revenue (volume, price, FX, acquisitions)
  2 Forecast COGS/gross margin, SG&A % sales
  3 Forecast non-operating items (interest, taxes)
  4 Project shares (options, buybacks)
  5 Build CF: NI + NCC – WCInv – CapEx, etc.
  6 Balance-sheet plug via cash or debt; derive valuation inputs (FCF, EPS).
• Working-capital forecasting using days ratios: $\text{Inv} = \frac{\text{DOH} \times \text{COGS}}{365}$ etc.
• Behavioral biases in forecasts: overconfidence, illusion of control, conservatism (anchoring), representativeness, confirmation; mitigations include scenario/sensitivity, outside views, peer review.
• Porter’s Five Forces determine industry pricing power & costs, shaping margin & growth forecasts.
• Inflation/deflation considerations: ability to pass through costs, contract lags, vertical integration, cost elasticity; use common-size to model margin sensitivity.
• Forecast horizon: driven by investment style, industry cycles, corporate events; beyond explicit period use normalized cash flows & terminal value assumptions.