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CFA1: Financial Statement Analysis

Financial statement

  • Financial Statement Analysis Framework
  1. State the objective and context. Determine what questions the analysis is meant to answer, the form in which it needs to be presented, and what resources and how much time are available to perform the analysis.
  2. Gather data. Acquire the company’s financial statements and other relevant data on its industry and the economy. Ask questions of the company’s management, suppliers, and customers, and visit company sites.
  3. Process the data. Make any appropriate adjustments to the financial statements. Calculate ratios. Prepare exhibits such as graphs and common-size balance sheets.
  4. Analyze and interpret the data. Use the data to answer the questions stated in the first step. Decide what conclusions or recommendations the information supports.
  5. Report the conclusions or recommendations. Prepare a report and communicate it to its intended audience. Be sure the report and its dissemination comply with the Code and Standards that relate to investment analysis and recommendations.
  6. Update the analysis. Repeat these steps periodically and change the conclusions or recommendations when necessary.

Balance sheet

  • Current ratio = current asset / current liability
    • Current asset = cash&equivalents + receivables + inventory
    • Current liability = total liability - long-term debt
  • Quick ratio = cash+marketable securities+receivables / current liability
  • Cash ratio = cash+marketable securities / current liability
  • Working capital = CA - CL
  • Asset = equity + current liabilities(CL) + long-term debt
  • Cash conversion cycle (in #days) = (receivables/sales + inventory/COGS – payables/COGS) * 365
  • Business risk = sales risk + operating risk(of EBIT)
  • Leverage = business risk + financial risk(carried by shareholders)
    • Operating leverage = %Δoperating earnings / %Δsales
  • Classified balance sheet: accouns grouped by type, subtotals presented for groups of assets

Income statement

  • Irregular items: reported net of taxes
    • include discontinued, extraordinary items, changes in accounting principle
  • FASB and IASB frameworks have similar constraints.

Cash flows

  • Total cash flow = ending cash balance - beginning cash balance
  • Free cash flow = CFO + {interest payment x (1-t)} - net capital expenditures(CFI)
  • Interest expense in operating cash flow

Cash Flow from Operations (CFO)

  • Direct method
Sales - Δaccount receivable
- COGS - Δinventory + Δaccount payable
- cash interest
 paid/received + Δinterest payable - tax
  • Indirect method - starts with Net income
    • investment profits and depreciation taken into account
Net income - profit from investment + depreciation
- Δaccount receivable - Δinventory
+ Δaccont payable + Δinterest payable

Cash Flow from Financing (CFF)

stock issue + bank notes
- dividend paid - mortgage payment
+ Δdividend payable + Δnotes payable

Cash Flow from Investment (CFI)

+ sales of equipment 
- equipment purchase

Revenue recognition

  • Percentage completion: when payment is assured
    • Completed contract: when estimates are not available
  • Depreciation
    • straight line: (price-salvage value) / depreciable life
    • double decling balance: 2 x price/depreciable life
    • reported in net of taxes
    • depreciation expense↑ -> tax payment↓, cash flow↑


  • In periods of rising prices, LIFO results
    • net income ↓
    • working capital ↓
    • inventory value ↓
    • taxes payable ↓
    • cash flow ↑
    • cost of goods sold ↑
  • LIFO inventory method permitted under US GAAP, but not under IFRS

Return on equity (ROE)

  • ROE = net income / # common shares
  • DuPont formula

Earnings Per Share (EPS)

Earnings per share = Net Income / Weighted Average Common Shares

  • Diluted EPS adjust for convertible bonds, preferred shares convertible, warrants
    • warrant adjust - if MV>warrant exercise price, at difference/MV
    • if no dividend declared, non-cumulative preferred stock no deducted from net income to calculate basic EPS
  • Growth rate(g) = ROE * (1-payout ratio)


  • lower early year profitability
  • Impairment: value of an asset carried on the books of a company cannot be recovered


  • pretax income ->
  • taxable income -> taxes payable
  • temporary difference - reverse in the future
  • permanent difference -> change reported tax rate
  • Take or pay agreement
    • obligation to pay minimum amount, regardless of whether product/service delivered
    • treated as liability, discounted value reflected in balance sheet


  • sales-type lease - gross profit is recognized at the inception
  • operating lease - no depreciation expense
    • tax benefits realized if lessee in low & lessor in high tax bracket
  • capital lease
    • defer the gain
    • depreciation(operating expense) = PV of asset / #lease period
    • interest expense(nonoperating expense) = PV of asset * implicit lease rate