CHAPTER 1

Introduction to Financial Statement Analysis

A comprehensive guide for CFA candidates covering the framework, users, and regulatory sources of financial analysis

Table of Contents

1

Introduction to Financial Analysis

Financial analysis is the process of using a company's financial data to assess its performance, financial health, and future prospects. It's essential for making informed investment, lending, and management decisions.

Who Uses Financial Analysis?

Different stakeholders have different goals:

DEBT INVESTORS (CREDITORS)

Banks, bondholders, and lenders. Their main concern is whether the company can repay its debt on time.

  • • Focus on liquidity (short-term cash flow)
  • • Focus on solvency (long-term ability to meet obligations)
  • • Key questions: Can the company pay interest? Will it repay the principal?

EQUITY INVESTORS (SHAREHOLDERS)

Owners of the company. They care about profitability, growth, and long-term value creation.

  • • Want rising earnings and strong returns on capital
  • • Desire sustainable dividends
  • • Key questions: Is the stock undervalued? Can the company grow earnings?

Different Perspectives

A company reports strong profits but has high debt and weak cash flow.

Creditors may avoid it

Too risky to repay loans

Equity investors might still buy

If they believe profits will grow and debt can be managed

2

The Financial Statement Analysis Framework

A structured, six-step framework ensures consistent and thorough analysis. This is the gold standard used by CFA charterholders and professional analysts.

1

Define the Purpose and Context

  • • Why are you analyzing the company? (Investment, credit, M&A?)
  • • Define the output: report, presentation, or internal memo
  • • Set time constraints and data availability
2

Collect Input Data

  • • Primary sources: Financial statements (I/S, B/S, SCF, Statement of Shareholders' Equity)
  • • Secondary sources: Industry reports, economic data, competitor filings
  • • Use reliable platforms: SEC EDGAR, Bloomberg, company websites
3

Process the Data

  • • Calculate financial ratios (profitability, liquidity, leverage, efficiency)
  • • Create common-size statements (e.g., income statement as % of revenue)
  • • Perform trend analysis and regression if needed
4

Analyze and Interpret

  • • Turn processed data into insights
  • • Compare results to peers, historical performance, and industry benchmarks
  • • Identify strengths, weaknesses, risks, and growth drivers
5

Develop and Communicate Conclusions

  • • Form clear conclusions: "The stock is undervalued," "Credit risk is high"
  • • Present findings in a well-structured report
  • • Disclose limitations and risks — required by CFA Institute Code of Ethics
6

Follow Up

  • • Financial analysis is not a one-time task
  • • Update your analysis with new data (quarterly earnings, economic shifts)
  • • Revise recommendations as needed
3

Scope of Financial Statement Analysis

Financial Reporting vs. Financial Analysis

FINANCIAL REPORTING

The process of preparing and disclosing financial statements. It provides the raw data.

Goal: Present a true and fair view of performance and financial position

FINANCIAL STATEMENT ANALYSIS

The process of interpreting that data to make decisions.

Goal: Evaluate profitability, risk, cash flow generation, and valuation

Primary Uses of Financial Analysis

Equity Valuation

Estimate intrinsic value to decide buy/sell/hold

Credit Risk Assessment

Evaluate ability to repay debt — critical for bond investors

M&A Due Diligence

Investigate target company's financial health

Performance Evaluation

Assess profitability of business units or subsidiaries

4

Regulated Sources of Information

Standard-Setting Bodies vs. Regulatory Authorities

STANDARD-SETTING BODIES

Develop accounting rules

  • • FASB: Sets U.S. GAAP for U.S. companies
  • • IASB: Sets IFRS, used globally

REGULATORY AUTHORITIES

Enforce compliance

  • • SEC: Regulates U.S. public companies
  • • IOSCO: Global body promoting investor protection

EUROPEAN CONTEXT

  • • IFRS is mandatory for all listed companies in the EU since 2005
  • • ESMA: Coordinates financial regulation across EU countries
  • • EFRAG: Advises the EU on IFRS adoption

Key SEC Filings (U.S. Public Companies)

Form Description
Form 10-K Annual report with audited financial statements and detailed business analysis
Form 10-Q Quarterly report with unaudited financial statements
Form 8-K Reports major events (e.g., CEO change, acquisition, bankruptcy)
Form 144 Notice of intent to sell restricted securities
Forms 3, 4, 5 Report insider trading by executives and directors

Key Components of Financial Reports

MANAGEMENT DISCUSSION & ANALYSIS (MD&A)

Narrative from management explaining financial results, trends, risks, and outlook. Required by SEC and encouraged under IFRS.

AUDITOR'S REPORT

Independent opinion on whether financial statements are fairly presented.

Unqualified (Clean): No material issues
Qualified: Some issues, but overall fair
Adverse: Major misstatements
Disclaimer: Couldn't gather enough evidence

CAMs/KAMs: Critical/Key Audit Matters highlight high-risk areas like revenue recognition.

FINANCIAL NOTES

Essential disclosures on accounting policies, estimates, contingent liabilities, and related-party transactions. Analysts must read these carefully — they often reveal key risks.

SEGMENT REPORTING

Companies must break down financial data by business unit or geography if segments are material and regularly reviewed by management.

5

Comparison of IFRS and U.S. GAAP

Most countries use IFRS, while U.S. public companies use U.S. GAAP. Analysts must understand key differences because they affect financial statements and comparability.

Key Differences Between IFRS and U.S. GAAP

Topic U.S. GAAP IFRS
Inventory Valuation Allows LIFO (Last-In, First-Out) Prohibits LIFO — only FIFO and weighted average allowed
Extraordinary Items Separately reported on income statement (rare) No segregation — all items part of normal operations
Development Costs Expensed as incurred (reduces profit) Can be capitalized if criteria met (e.g., technical feasibility)
Inventory Write-Down Reversals Not allowed — once written down, stays down Allowed if market value recovers

WHY THESE DIFFERENCES MATTER

  • • LIFO vs. FIFO: In inflation, LIFO increases COGS and lowers profit → lower taxes but lower reported earnings
  • • Development costs: Capitalizing R&D under IFRS increases assets and future profits; expensing under GAAP reduces current profit
  • • Write-down reversals: IFRS allows profit boosts if inventory value recovers — can be used to manage earnings

Stay Updated on Standard Changes

Accounting standards evolve. The IASB, FASB, and CFA Institute regularly issue updates. Analysts must monitor changes to understand their impact on financials and valuations.

6

Other Sources of Information

Smart analysts go beyond financial statements to get a complete picture.

Issuer Sources (From the Company)

Earnings Calls

Listen to management discuss results and answer analyst questions

Investor Presentations

Slides from conferences — often include strategic plans and KPIs

Press Releases

Announcements on earnings, M&A, or new products

Direct Communication

Talking to IR teams or management (where permitted)

Third-Party Sources

PUBLIC SOURCES

  • • Industry reports (McKinsey, Gartner)
  • • Economic data (GDP, inflation, employment)
  • • News outlets (Reuters, Bloomberg)
  • • Social media (sentiment analysis)

PROPRIETARY SOURCES

  • • Analyst research reports (sell-side)
  • • Data platforms: Bloomberg, FactSet, Wind
  • • Consultancy reports (supply chain risks)

Proprietary Primary Research

Some analysts conduct their own research for unique insights:

Customer Surveys

Store Visits

Expert Interviews

This "on-the-ground" research can uncover trends before they appear in financials.

7

Exam Focus Points

Key Exam Areas

This reading typically accounts for 2-3% of Level I exam weight. Master these areas:

  • • The 6-step framework - memorize the sequence
  • • Differences between IFRS and U.S. GAAP - particularly inventory methods and development costs
  • • SEC filings - know when 10-K, 10-Q, and 8-K are used
  • • Audit opinion types and their implications

Common Pitfalls

Standard-Setters vs. Regulators: FASB sets U.S. GAAP standards; IASB sets IFRS. The SEC enforces compliance but does not create standards.

LIFO Availability: LIFO is only allowed under U.S. GAAP, not under IFRS.

Development Costs: U.S. GAAP expenses all R&D. IFRS allows capitalization of development costs (not research) if criteria are met.

Audit Opinions: Qualified means some issues exist but statements are overall fair. Adverse means material misstatements exist.

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