Refresher Reading
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2021 Curriculum CFA Program Level I Financial Reporting and Analysis
Introduction
This reading presents several important applications of financial statement analysis. Among the issues we will address are the following:
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What are the key questions to address in evaluating a company’s past financial performance?
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How can an analyst approach forecasting a company’s future net income and cash flow?
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How can financial statement analysis be used to evaluate the credit quality of a potential fixed-income investment?
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How can financial statement analysis be used to screen for potential equity investments?
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How can differences in accounting methods affect financial ratio comparisons between companies, and what are some adjustments analysts make to reported financials to facilitate comparability among companies.
The reading “Financial Statement Analysis: An Introduction” described a framework for conducting financial statement analysis. Consistent with that framework, prior to undertaking any analysis, an analyst should explore the purpose and context of the analysis. The purpose and context guide further decisions about the approach, the tools, the data sources, and the format in which to report results of the analysis, and also suggest which aspects of the analysis are most important. Having identified the purpose and context, the analyst should then be able to formulate the key questions that the analysis must address. The questions will suggest the data the analyst needs to collect to objectively address the questions. The analyst then processes and analyzes the data to answer these questions. Conclusions and decisions based on the analysis are communicated in a format appropriate to the context, and follow-up is undertaken as required. Although this reading will not formally present applications as a series of steps, the process just described is generally applicable.
Section 2 of this reading describes the use of financial statement analysis to evaluate a company’s past financial performance, and Section 3 describes basic approaches to projecting a company’s future financial performance. Section 4 presents the use of financial statement analysis in assessing the credit quality of a potential debt investment. Section 5 concludes the survey of applications by describing the use of financial statement analysis in screening for potential equity investments. Analysts often encounter situations in which they must make adjustments to a company’s reported financial results to increase their accuracy or comparability with the financials of other companies. Section 6 illustrates several common types of analyst adjustments. Section 7 presents a summary, and practice problems in the CFA Institute multiple-choice format conclude the reading.
Learning Outcomes
The member should be able to:
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evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance;
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forecast a company’s future net income and cash flow;
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describe the role of financial statement analysis in assessing the credit quality of a potential debt investment;
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describe the use of financial statement analysis in screening for potential equity investments;
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explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company.
Summary
This reading described selected applications of financial statement analysis, includingthe evaluation of past financial performance, the projection of future financial performance,the assessment of credit risk, and the screening of potential equity investments.In addition, the reading introduced analyst adjustments to reported financials. Inall cases, the analyst needs to have a good understanding of the financial reportingstandards under which the financial statements were prepared. Because standards evolveover time, analysts must stay current in order to make good investment decisions.
The main points in the reading are as follows:
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Evaluating a company’s historical performance addresses not only what happened but also the causes behind the company’s performance and how the performance reflects the company’s strategy.
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The projection of a company’s future net income and cash flow often begins with a top-down sales forecast in which the analyst forecasts industry sales and the company’s market share. By projecting profit margins or expenses and the level of investment in working and fixed capital needed to support projected sales, the analyst can forecast net income and cash flow.
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Projections of future performance are needed for discounted cash flow valuation of equity and are often needed in credit analysis to assess a borrower’s ability to repay interest and principal of a debt obligation.
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Credit analysis uses financial statement analysis to evaluate credit-relevant factors, including tolerance for leverage, operational stability, and margin stability.
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When ratios constructed from financial statement data and market data are used to screen for potential equity investments, fundamental decisions include which metrics to use as screens, how many metrics to include, what values of those metrics to use as cutoff points, and what weighting to give each metric.
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Analyst adjustments to a company’s reported financial statements are sometimes necessary (e.g., when comparing companies that use different accounting methods or assumptions). Adjustments can include those related to investments; inventory; property, plant, and equipment; and goodwill.
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Financial Analysis
Equity Investments
Fundamental Analysis
Valuation
