2.1 Introduction to financial statement analysis
** This note is summarized by Hui Wang.
The candidate should be able to:
a. Discuss the roles of financial reporting and financial statement analysis;
b. Discuss the role of key financial statements (income statement, balance sheet,
cash flow statement and statement of changes in owners’ equity) in evaluating a
company’s performance and financial position;
c. Discuss the importance of financial statement notes and supplementary
information (including disclosures of accounting methods, estimates and
assumptions) and management’s discussion and analysis;
d. Discuss the objective of audits of financial statements, the types of audit reports,
and the importance of effective internal controls;
e. Identify and explain information sources other than annual financial statements
and supplementary information that analysts use in financial statement analysis;
f. Describe the steps in the financial statement analysis framework.
Liquidity & solvency
Liquidity describes the ability of an asset to be converted into cash quickly and without
any price discount. In financial statement analysis, it measures the extent to which a firm
has cash to meet immediate and short-term obligations. Solvency measures the ability of
a firm to meet its long-term obligations.
Financial statements and supplementary information
The four key financial statements are income statement, balance sheet, statement of cash
flows, and statement of changes in owner’s equity.
Supplementary information can be found from:
a. Footnotes and supplementary schedules;
b. Management’s discussion and analysis (MD&A);
c. The external auditor’s reports.
Income statement is a financial statement that measures a company’s financial
performance over a specific accounting period. It gives a summary of how the business
incurs its revenues and expenses through both operating and non-operating activities. It
also shows the net profit or loss incurred over a specific accounting period, typically over
a fiscal quarter or year. Income statement is also known as a statement of operations or
profit and loss (R&L) statement.
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Income statements are reported on a consolidated basis-the revenues and expenses of
affiliated companies under the control of the reporting company are incorporated into its
income statement. The basic equation underlying the income statement is,
Revenue – Expenses = Net income
Balance sheet is a financial statement that summarizes a company’s assets, liabilities and
shareholders’ equity at a specific point in time. These three balance sheet segments give
investors an idea as to what the company owns and owes, as well as the amount invested
by the shareholders. Balance sheet is also known as the statement of financial position or
statement of financial condition. The basic equation underlying the balance sheet is,
Assets = Liabilities + Owners’ equity
Cash flow statement
The cash flow statement reports the cash generated and used during the time interval
specified in its heading. The cash flow statement organizes and reports the cash generated
and used in the following categories:
Operating activities Involve transactions that enter into the
determination of net income and are
primarily activities that comprise the daily
business functions of a company
Investing activities Report the purchase and sale of long-term
investments and property, plant and
Financing activities Report the issuance and repurchase of the
company’s own bonds and stock and the
payment of dividends
Financial flexibility refers to a company’s ability to take advantage of unforeseen
opportunities or its ability to deal with unexpected events depending on the company’s
financial policies and financial structure.
Statement of changes in owners’ equity
The statement of changes in owners’ equity identifies the changes in equity by
reconciling the beginning and ending equity (shown in the balance sheets.) This change is
determined by comparing such items as retained earnings, contributed capital and the
valuation of assets. The change in equity occurs as a result of business earnings, a change
in asset valuation, or the actions of owners who contribute more capital or withdraw
capital from the business. The statement of changes in owners’ equity is also called
statement of shareholders’ equity, or statement of retained earnings.
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Financial notes and supplementary schedules
The financial notes and supplementary schedules provide explanatory information about
a. The methods and assumptions used to prepare the financial statements
b. Business acquisitions and disposals
c. Commitments and contingencies
d. Legal proceedings
e. Stock option and other employee benefit plans
f. Related-party transactions
g. Significant customers
h. Subsequent events
i. Business and geographic segments
j. Quarterly financial data
Management’s discussion and analysis
The management’s discussion and analysis (MD&A) seeks to force a company’s
management to take responsibility for their actions and those of the company. In MD&A,
a company’s management offer details about issues such as revenues, past and future
plans for the company, uncertainty within the company, sources of liquidity, cash flow
problems, liabilities, raising funds, and materiality. The MD&A is intended to assist
investors in the understanding and assessment of significant changes and trends, as well
as risks and uncertainties, related to the results of operations and the financial condition
of the companies. It also disclose the critical accounting policies that require management
to make subjective judgments and that have a significant impact on reported financial
The independent audit report provides reasonable assurance that the financial statements
are fairly presented-it is highly possible that the audited financial statements are free from
material error, fraud, or illegal acts that have a direct effect on the financial statements.
Note that independent auditors cannot express an opinion that provides absolute
assurance about the accuracy or precision of the financial statements.
Unqualified audit opinion (or a clean The financial statements are presented
opinion) fairly in conformity with GAAP (U.S) or
give a “truce and fair view” (international)
Qualified audit opinion Is issued when there is: (1) scope
limitation, or (2) departure from accounting
Adverse audit opinion Is issued when the financial statements do
not present the company’s financial
position in conformity with accounting
standards and are not fairly presented
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Disclaimer of opinion Issued when the auditor is unable to form
an opinion on an entity’s financial
statements. A disclaimer may be issued in
cases when: (1) the auditor is not
independent with respect to the entity
under audit; (2) a material scope limitation
exists; (3) a significant uncertainty exists
In the U.S., the auditors are required to express an opinion on companies’ internal control
systems under the Sarbanes-Oxley Act.
Proxy statement is a document intended to provide shareholders with information
necessary to voted in an informed manner on matters to be brought up at stockholders’
meeting. It lists the items to be voted on including nominees for directorships, the
auditing firm recommended by directors, the salaries of top officers and directors, and
resolutions submitted by management and stockholders and discloses any potential
conflicts of interest that my exist between management, the board, and shareholders.
Interim reports, also known as interim statement is short, unaudited financial statement
issued monthly, quarterly, or half-yearly by a firm and generally shows pretax profit,
estimated tax liabilities, earnings available for the interim divided, and other such
Financial statement analysis framework
Phase Sources of information Output
1. Articulate the The nature of the Statement of the
purpose and context analyst’s function, purpose or objective
of the analysis such as evaluating of analysis.
an equity or debt A list (written or
investment or unwritten) of
issuing a credit specific questions to
rating. be answered by the
with client or Nature and contend
supervisor on needs of report to be
and concerns. provided.
Institutional Timetable and
guidelines related to budgeted resources
developing specific for completion.
2. Collect data Financial Organized financial
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statements, other statements.
financial data, Financial data tables.
questionnaires, and Completed
industry/economic questionnaires, if
Company site visits
(e.g., to production
facilities or retail
3. Process data Data from the Adjusted financial
previous phase. statements.
Ratios and graphs.
4. Analyze/interpret the Input data as well Analytical results.
processed data as processed data.
5. Develop and Analytical results Analytical report
communicate and previous answering questions
conclusions and reports. posed in Phase 1.
recommendations Institutional Recommendation
(e.g., with an guidelines for regarding the
analysis report) published reports. purpose of the
analysis, such as
whether to make an
investment or grant
6. Follow up Information Updated reports and
gathered by recommendations.
steps as necessary
whether changes to
(from CFA® Program Curriculum)
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Exercise Problems: (provided by Stalla PassMaster for CFA Exams.)
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