Financial Statement Analysis — Study Notes

CFA® Level I topic weight 11–14% · one of the heavyweight topics

Statements & recognition

The three statements link: net income flows into retained earnings on the balance sheet and starts the indirect-method cash flow statement; ending cash on the cash flow statement is the balance-sheet cash line. Accrual accounting recognizes revenue when earned and expenses when incurred — timing differences between earnings and cash are where analysis lives.
Revenue recognition (converged five-step model): identify the contract, identify performance obligations, determine the transaction price, allocate it to the obligations, recognize revenue as each obligation is satisfied — at a point in time or over time.
Expense recognition: match costs to related revenue (COGS), expense period costs as incurred, and allocate long-lived asset costs via depreciation/amortization. Aggressive capitalizing of what should be expensed inflates current earnings and operating cash flow.

Earnings per share

Basic EPS = (net income − preferred dividends) ÷ weighted-average shares outstanding.
Diluted EPS re-computes as if convertibles converted (if-converted method: add back the convertible bond’s after-tax interest or the convertible preferred’s dividends, add the shares) and as if options exercised (treasury stock method: only the net new shares after assumed buybacks at the average price are added, and only when options are in the money).
Antidilutive securities are excluded: if a conversion would raise EPS, leave it out. Diluted EPS can never exceed basic EPS.

Inventory, long-lived assets & taxes

FIFO vs LIFO vs weighted average: with rising prices and stable inventory, LIFO gives higher COGS, lower gross profit, lower taxes, and lower (older-cost) balance-sheet inventory; FIFO gives the more current inventory value. LIFO is permitted under US GAAP only — IFRS prohibits it. The LIFO reserve converts LIFO figures to FIFO for comparison.
Capitalize vs expense: capitalizing shifts cost from the income statement to the balance sheet — higher early profits, higher assets and equity, and the outflow reported as investing rather than operating. The total cost over the asset’s life is identical; only timing and classification differ.
Depreciation: straight line spreads cost evenly; accelerated methods (e.g., double declining balance) front-load expense. Estimates — useful life and salvage value — are management levers that change reported earnings without changing cash.
Impairment writes an asset down when its carrying amount is no longer recoverable; under IFRS impairments of long-lived assets may later be reversed (up to the original path), under US GAAP they may not. IFRS also permits the revaluation model for PP&E; US GAAP requires historical cost.
Deferred taxes: temporary differences between accounting and tax bases create deferred tax liabilities (e.g., faster tax depreciation) or deferred tax assets (e.g., loss carryforwards, warranty accruals). A valuation allowance reduces a DTA that is unlikely to be realized — watch allowance changes as an earnings-management signal.

Cash flow & ratios

Classification: operating (core business), investing (long-term assets), financing (capital providers). Under US GAAP interest paid/received and dividends received are operating and dividends paid are financing; IFRS allows choices (interest paid may be operating or financing, and so on) — a classic comparability question.
Indirect method: start with net income, add back non-cash charges, and adjust for working-capital changes — an increase in receivables or inventory uses cash; an increase in payables provides cash.
Free cash flow to the firm: FCFF = CFO + interest expense × (1 − tax rate) − fixed capital investment. Free cash flow to equity subtracts what belongs to lenders: FCFE = CFO − FCInv + net borrowing.
Ratio families: liquidity (current ratio, quick ratio), solvency (debt-to-equity, interest coverage = EBIT ÷ interest), profitability (gross/operating/net margins, ROA, ROE), and activity (turnover ratios, days sales outstanding).
DuPont decomposition: ROE = net profit margin × asset turnover × financial leverage. The five-way version splits margin further into tax and interest burdens — it tells you why ROE moved, which is what questions ask.
Reporting-quality red flags: revenue growth outpacing receivables-adjusted cash collection, repeated one-time items, aggressive estimate changes, and CFO persistently below net income.

Common traps

Applying LIFO under IFRS — IFRS prohibits LIFO; any IFRS-reporting firm in a question cannot be using it.
Including antidilutive convertibles in diluted EPS — test each security; anything that raises EPS is excluded.
Forgetting the working-capital signs in the indirect method — rising receivables and inventory reduce CFO; rising payables increase it.
Treating capitalizing vs expensing as a total-profit difference — lifetime totals match; the difference is timing, ratios, and CFO vs CFI classification.
Assuming interest paid is always operating — that is US GAAP; IFRS permits financing classification, which changes CFO comparisons.

For exam preparation reference only — original condensed summaries of publicly known Level I curriculum concepts. Accounting standards evolve; verify against current IFRS/US GAAP guidance. Independent study aid. CFA Institute does not endorse, promote, or warrant the accuracy or quality of this product. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.