Course Content
INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS
This topic covers the LOS (Learning Outcome Statements) 19 as covered by the CFA institute. According to this statement, after going through this reading, a student shall be able to: a. Describe the role of financial reporting and financial statement analysis. b. Describe the role of key financial statements, i.e. i. Statement of financial position, ii. Statement of comprehensive income, iii. Statement of changes in equity, and iv. Statement of cash flows. c. Describe the importance of financial statement notes and supplementary information. This includes: i. Disclosures of accounting policies, ii. Methods, and iii. Estimates used in financial reporting. d. Describe the: i. Objectives of audit of financial statements, ii. the types of audit reports, and iii. the importance of effective internal controls. e. Identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information; f. Describe the steps in the financial statement analysis framework.
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Introduction
00:00
Role of Financial Statements and Financial Statement Analysis
00:00
Major Financial Statements
00:00
Other Documents
00:00
Other Sources of Information
00:00
Auditor’s Report
00:00
Internal Control
00:00
Financial Statement Analysis Framework
00:00
FINANCIAL REPORTING STANDARDS
This part of the study session 6 is covered under the LOS (Learning Outcome Statement) 20, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation; b. describe roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions; c. describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements; d. describe general requirements for financial statements under International Financial Reporting Standards (IFRS); e. describe implications for the financial analysis of differing financial reporting systems and the importance of monitoring developments in financial reporting standards; analyze company disclosures of significant accounting policies. There are revisions and amendments that keep happening to the existing financial reporting standards o n a regular basis. It is thus advisable to the students to keep updating themselves regarding such changes to maintain a decent understanding regarding the financial reporting framework towards a better analysis.
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Introduction
00:00
The Objectives of Financial Reporting
00:00
Standard Setting Bodies and Regulatory Authorities
00:00
Convergence of Global Financial Reporting Standards
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International Financial Reporting Standards Framework
00:00
Effective Financial Reporting
00:00
Comparison of IFRS with Alternative Reporting Systems
00:00
UNDERSTANDING INCOME STATEMENTS
This part of the study session 7 is covered under the LOS (Learning Outcome Statement) 21, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. describe the components of the income statement and alternative presentation formats of that statement; b. describe general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and implications of revenue recognition principles for financial analysis; c. calculate revenue given information that might influence the choice of revenue recognition method; d. describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis; e. describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, extraordinary items, unusual or infrequent items) and changes in accounting standards; f. distinguish between the operating and non-operating components of the income statement; g. describe how earnings per share are calculated and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures; h. distinguish between dilutive and anti-dilutive securities, and describe the implications of each for the earnings per share calculation; i. convert income statements to common-size income statements; j. evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement; k. describe, calculate, and interpret comprehensive income; l. describe other comprehensive income, and identify major types of items included in it.
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Introduction
00:00
Income Statement Components
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Presentation Format of Income Statements
00:00
Revenue Recognition
00:00
Expense Recognition
00:00
Non- Recurring / Operating Items
00:00
Earnings Per Share
00:00
Income Statement Analysis
00:00
UNDERSTANDING BALANCE SHEETS
This part of the study session 7 is covered under the Reading 22, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. describe the elements of the balance sheet: assets, liabilities, and equity; b. describe uses and limitations of the balance sheet in financial analysis; c. describe alternative formats of balance sheet presentation; d. distinguish between current and non-current assets, and current and non-current liabilities; e. describe different types of assets and liabilities and the measurement bases of each; f. describe the components of shareholders’ equity; g. convert balance sheets to common-size balance sheets and interpret common-size balance sheets; h. calculate and interpret liquidity and solvency ratios.
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Introduction
00:00
Elements of Balance Sheet
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Uses and Limitations of Balance Sheet
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Alternative Formats of Balance Sheet
00:00
Current Assets/Liabilities vs. Non-Current Assets/Liabilities
00:00
Types of Assets and Liabilities
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Vertical Common Sized Balance Sheet
00:00
Calculation and Interpretation of Solvency and Liquidity Ratios
00:00
UNDERSTANDING CASH FLOW STATEMENTS
This part of the study session 7 is covered under the Reading 23, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items; b. describe how non-cash investing and financing activities are reported; c. contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP); d. distinguish between the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method; e. describe how the cash flow statement is linked to the income statement and the balance sheet; f. describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data; g. convert cash flows from the indirect to direct method; h. analyze and interpret both reported and common-size cash flow statements; i. calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
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Introduction
00:00
Components of Cash Flow Statements
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Reporting of Non-Cash Investing and Financing Activities
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Difference between the Cash Flow Statement Prepared Under IFRS and US GAAP
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Difference between Direct and Indirect Method of Preparing Cash Flow Statement
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Other Relationships in Cash Flow Statement
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Steps in Preparation of Cash Flow Statements
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Conversion of Cash Flow from Indirect to Direct Method
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Analysis and Interpretation of Cash Flow Statement
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Calculation and Interpretation of Cash flow Ratios
00:00
FINANCIAL ANALYSIS TECHNIQUES
This part of the study session 7 is covered under the Reading 24, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. describe tools and techniques used in financial analysis, including their uses and limitations; b. classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios; c. describe relationships among ratios and evaluate a company using ratio analysis; d. demonstrate the application of DuPont analysis of return on equity, and calculate and interpret effects of changes in its components; e. calculate and interpret ratios used in equity analysis and credit analysis; f. explain the requirements for segment reporting, and calculate and interpret segment ratios; g. describe how ratio analysis and other techniques can be used to model and forecast earnings.
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Introduction
00:00
Tools and Techniques Used in Financial Analysis
00:00
Classifications, Calculation, and Interpretation of Various Ratios
00:00
Du-Pont Analysis
00:00
Equity and Credit Analysis
00:00
Segment Reporting
00:00
Use of Ratio Analysis to Model and Forecast Earnings
00:00
INVENTORIES
This part of the study session 8 is covered under Reading 25, as covered by the CFA Institute. The candidate should be able to: a distinguish between costs included in inventories and costs recognised as expenses in the period in which they are incurred; b describe different inventory valuation methods (cost formulas); c calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using perpetual and periodic inventory systems; d calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods; e explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios; f convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison; g describe the measurement of inventory at the lower of cost and net realisable value; h describe implications of valuing inventory at net realisable value for financial statements and ratios; i describe the financial statement presentation of and disclosures relating to inventories; j explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information; k calculate and compare ratios of companies, including companies that use different inventory methods; l analyze and compare the financial statements of companies, including companies that use different inventory methods.
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Introduction
00:00
Product Cost and Period Cost
00:00
Inventory Valuation Method
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Calculation of COGS and Value of Ending Inventory
00:00
Concept of LIFO Reserve and Conversion of LIFO to FIFO / AVCO Method of Valuation
00:00
Measurement of Inventory
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Presentation and Disclosures of Inventory and Related Items
00:00
Issues Involved in Evaluating Inventory
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Impact of Choice of Valuation Methods on the Ratios
00:00
Inventory Analysis
00:00
LONG-LIVED ASSETS
This part the study session 8 is covered under Reading 26, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. distinguish between costs that are capitalised and costs that are expensed in the period in which they are incurred; b. compare the financial reporting of the following types of intangible assets: purchased, internally developed, acquired in a business combination; c. explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios; d. describe the different depreciation methods for property, plant, and equipment and calculate depreciation expense; e. describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements, and ratios; f. describe the different amortisation methods for intangible assets with finite lives and calculate amortisation expense; g. describe how the choice of amortisation method and assumptions concerning useful life and residual value affect amortisation expense, financial statements, and ratios; h. describe the revaluation model; i. explain the impairment of property, plant, and equipment and intangible assets; j. explain the derecognition of property, plant, and equipment and intangible assets; k. explain and evaluate how impairment, revaluation, and derecognition of property, plant, and equipment and intangible assets affect financial statements and ratios; l. describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets; m. analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets; n. compare the financial reporting of investment property with that of property, plant, and equipment.
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Introduction
00:00
Capitalization of Cost Vs. Expensing
00:00
Intangible Assets
00:00
Impact of Capitalizing vs. Expensing the Assets on Financial Statements and Ratios
00:00
Calculation of Depreciation Expense
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Impact of Choices for Depreciation on Financial Statements and Ratios
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Amortization
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Impact of Choices for Amortization on Financial Statements and Ratios
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Revaluation Model
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Impairment of Assets
00:00
De-recognition of Assets
00:00
Effects of Revaluation, Impairment, and De-Recognition
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Disclosures
00:00
Evaluation of Important Ratios
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Investment Property
00:00
Leasing
00:00
INCOME TAXES
This part of the study session 8 is covered under Reading 28, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense; b. explain how deferred tax liabilities and assets are created and the factors that determine how a company’s deferred tax liabilities and assets should be treated for the purposes of financial analysis; c. calculate the tax base of a company’s assets and liabilities; d. calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax liabilities, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate; e. evaluate the impact of tax rate changes on a company’s financial statements and ratios; f. distinguish between temporary and permanent differences in pre-tax accounting income and taxable income; g. describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements; h. compare a company’s deferred tax items; i. analyze disclosures relating to deferred tax items and the effective tax rate reconciliation, and explain how information included in these disclosures affects a company’s financial statements and financial ratios; j. identify the key provisions of and differences between income tax accounting under International Financial Reporting Standards (IFRS) and the US generally accepted accounting principles (GAAP).
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Introduction
00:00
Definition of Key Terms
00:00
Creation and Treatment of Deferred Tax Assets / Liabilities
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Tax Base
00:00
Calculation of Tax Expense, Income Tax Payable, Deferred Tax Asset / Liability
00:00
Changes in Tax
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Differences in Temporary and Permanent Differences
00:00
Valuation Allowance
00:00
Current vs. Deferred Tax
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Disclosure Requirements for Deferred Tax Assets / Liabilities
00:00
Key Differences in the Tax Accounting Under IFRS and GAAP
00:00
NON-CURRENT (LONG-TERM) LIABILITIES
This part of the study session 8 is covered under Reading 28, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. determine the initial recognition, initial measurement, and subsequent measurement of bonds; b. describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments; c. explain the derecognition of debt; d. describe the role of debt covenants in protecting creditors; e. describe the financial statement presentation of and disclosures relating to debt; f. explain motivations for leasing assets instead of purchasing them; g. explain the financial reporting of leases from a lessee’s perspective; h. explain the financial reporting of leases from a lessor’s perspective; i. compare the presentation and disclosure of defined contribution and defined benefit pension plans; j. calculate and interpret leverage and coverage ratios.
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Introduction
00:00
Bonds
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Methods of Accounting for Bonds
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Derecognition of Bonds
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Debt Covenants
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Presentation and Disclosure of Bonds
00:00
Leases
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Benefits of Leasing
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Financial Reporting From Lessee’s and Lessor’s Perspective
00:00
Pension Plans
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Leverage and Coverage Ratios
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FINANCIAL REPORTING QUALITY
This part of the study session 9 is covered under Reading 29, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. distinguish between financial reporting quality and quality of reported results (including quality of earnings, cash flow, and balance sheet items); b. describe a spectrum for assessing financial reporting quality; c. distinguish between conservative and aggressive accounting; d. describe motivations that might cause management to issue financial reports that are not high quality; e. describe conditions that are conducive to issuing low-quality, or even fraudulent, financial reports; f. describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms; g. describe presentation choices, including non-GAAP measures, that could be used to influence an analyst’s opinion; h. describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items; i. describe accounting warning signs and methods for detecting manipulation of information in financial reports.
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Introduction
00:00
Difference between Financial Reporting Quality and Quality of Reported Results
00:00
Spectrum for Assessing the Financial Reporting Quality
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Conservative and Aggressive Accounting
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Motivation Behind Low Quality Financial Reports
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Conditions Conducive to Low Quality Reporting
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Mechanisms That Discipline Financial Reporting Quality and Limitations to Mechanisms
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Presentation Choices That Could Influence Analyst’s Opinion
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Methods Used to Manage Earnings, Cash Flow & Balance Sheet Items
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Warning Signs Indicating Manipulation of Financial Reports
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APPLICATIONS OF FINANCIAL STATEMENT ANALYSIS
This part of the study session 9 is covered under Reading 30, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance; b. forecast a company’s future net income and cash flow; c. describe the role of financial statement analysis in assessing the credit quality of a potential debt investment; d. describe the use of financial statement analysis in screening for potential equity investments; e. explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company.
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Introduction
00:00
Evaluation of Performance Vis-à-vis Strategy
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Forecasting Company’s Net Income Cash Flow
00:00
Assessing the Credit Quality
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Screening for Potential Equity Investment
00:00
Adjustment Necessary to Facilitate Comparisons
00:00
Financial Reporting and Analysis
About Lesson

As per the LOS B, we are required to:

describe the roles of the statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows in evaluating a company’s performance and financial position.

The analysis of financial statement is only possible if there are financial reports which are authentic and accurate. Some of the major financial reports based on which the decision-makers make a decision are:

a.  Balance Sheet,

b.  Statement of Comprehensive Income,

c.  Statement of Changes in Equity, and

d.  Statement of Cash Flow

1.          Balance Sheet / Statement of Financial Position

Statement of Financial Position or Balance Sheet, as it is commonly called, presents the financial position of the company as at the date of its reporting (usually at the end of the reporting period).

It discloses the resources that the reporting entity controls (i.e. its assets) and its obligations to the outside parties, such as lenders and creditors (i.e. liabilities) on the reporting date. The third part of the balance sheet is the owner’s equity. It is the amount attributable to its shareholders by the company.

The three main components of the balance sheet (i.e. assets, liabilities, and owner’s equity) are associated through the following accounting equation:

Assets = Liabilities + Owner’s Equity

All the financial statements of the reporting entities are usually prepared as per the reporting norms applicable to the entity such as the accepted accounting principles or the IFRSs. An example of the balance sheet prepared as per the IFRS is:

BALANCE SHEET AS AT
Particulars Notes

Year ended
 

20XX

20XX
NON CURRENT ASSETS      
Property, plant and equipment and Investment Property      
Goodwill      
Advances for Capital Assets      
Intangible assets      
Investments      
Investments in associates      
Available for sale investments      
Receivables and other non-current Assets      
Deferred tax assets      
TOTAL NON CURRENT ASSETS  

–

–
       
CURRENT ASSETS      
Inventories      
Trade receivables      
Other current assets      
Income tax assets      
Investments and financial receivables      
Cash and cash equivalents      
TOTAL CURRENT ASSETS  

–

–
       
TOTAL ASSETS  

–

–
       
SHAREHOLDERS’ EQUITY      
Share capital      
Reserves      
Retained earnings      
TOTAL SHAREHOLDERS’ EQUITY  

–

–
       
NON CURRENT LIABILITIES      
Interest-bearing loans and short term borrowings      
Employee benefits liabilities      
Provisions      
Deferred tax liabilities      
TOTAL NON CURRENT LIABILITIES  

–

–
       
CURRENT LIABILITIES      
Banks overdrafts and short-term borrowings      
Interest-bearing loans and short term borrowings      
Trade payables      
Provisions      
Income tax liabilities      
Other liabilities      
TOTAL CURRENT LIABILITIES  

–

–
       
TOTAL LIABILITIES  

–

–
       
TOTAL SHAREHOLDERS’ EQUITY AND LIABILITIES  

–

–

2.         Comprehensive Income Statement

This statement shows the financial results of all the business’s commercial activities during the entire reporting period. It shows all the changes in equity except for the shareholder’s transactions. There are mainly three elements of the income statements:

a.  These are the inflows from the major business activities of the reporting entity. These include the sale of goods, rendering of services, or other activities that constitute the central operations of the company.

b.  Other Income. These include all the incomes other than those that are central to the entity’s business operations. For example, the interest incomes or dividends from the investments (where investment is not the central business activity of the entity).

c.  The expenses are all the outflows that go into earning these revenues and other incomes of the reporting entity.

Under IFRS the other incomes are combined in a single statement. The example of a statement of comprehensive income prepared under IFRS is as follows:

IFRS- Income Statement for the year ended ….
       
   

Year ended
  Note

20XX

20XX
Continuing operations      
Revenue      
Cost of sales      
Gross Profit      
       
Distribution expenses      
Marketing expenses      
Occupancy expenses      
Administration expenses      
Finance costs      
Other expenses      
Other income      
Other (losses)/gains – net      
Operating profit1      
       
Finance income      
Finance costs      
Finance costs – net      
Share of (loss)/profit of associates      
Profit before income tax      
       
Income tax expense      
Profit for the year      
       
Earnings per share      
Basic earnings per share      
Diluted earnings per share      

3.         Statement of Changes in Equity

This statement, also known as ‘statement of owner’s equity’ and ‘statement of changes in shareholder’s equity’, reports the changes in the value of the owner’s investment in the business. It shows the beginning balance, any increase or decrease, and closing balance of each element of the equity. The example of a statement of changes in equity of a company is as follows:

Statement of changes in equity for the year ended

 31st December 20xx

 

Share capital

Retained earnings

Revaluation Surplus

Total equity

 

        

 Balance at 1 January 20XX

     

–

 Changes in accounting policy

      

–

 

        

 Restated balance

–

–

–

–

 

        

 Changes in equity for the year 20XX

       

 

        

 Issue of share capital

      

–

 Dividends

      

–

 Income for the year

      

–

 Revaluation gain 

      

–

 

        

 Balance at 31 December 20XX

–

–

–

–

 

        

 Changes in equity for 20XX

       

 

        

 Issue of share capital

      

–

 Dividends

      

–

 Income for the year

      

–

 Revaluation gain 

      

–

 

        

 Balance at 31 December 20XX

–

–

–

–

4.         Statement of Cash Flows

The statement of cash flows reports the receipt and payments of cash during the reporting period in the reporting entity. Although, the profitability of the company could be accessed through the statement of comprehensive income and balance sheet of the company; the statement of cash flows is still one of the most important financial statements. This is because the cash flow from the business activities is also extremely important. It is the capability to generate cash flows that determine the real worth of the business (this would be discussed in detail in the capital budgeting section of the financial management). Also, the profit represented by the figures in the income statement is only the accounting profit (since it is based on judgments and estimates of management); the cash flows as represented by the cash flow statement are real economic flows. Hence it becomes imperative to include the statement of cash flows in the major financial statements reported by the entity.

The statement of cash flows has three major components. These are:

a.  Cash from operating activities. It includes the cash inflow and outflows from the normal business operations of the entity.

b.  Cash from investing activities. This section includes the cash inflow and outflows from the sale and acquisition of the long-term assets of the company such as factory buildings, plants, etc.

c.  Cash from financing activities. This includes cash inflows and outflows from activities that pertain to the raising and repayment of the capital for the business operations.

The example of a model statement of cash flow for a business is as follows:

   Statement of cash flows for the year ended

     

 Amount

 Amount
 Cash flows from operating activities    
 Profit before taxation        
 Adjustments for:        
   Depreciation    
   Amortization    
   Investment income    
   Interest expense    
     

–

  
   Increase in trade receivables    
   Increase in inventories    
   Increase in short-term borrowings  
   Increase in trade payables    
 Cash generated from operations  

–

  
 Interest paid        
 Income tax paid        
 Net cash from operating activities    

–
 Cash flows from investing activities    
 Purchase of property, plant, and equipment    
 Purchase of intangible assets      
 Proceeds from the sale of equipment      
 Proceeds from the sale of intangible assets    
 Interest received        
 Net cash used in investing activities  

–
 Cash flows from financing activities    
 Proceeds from issue of share capital    
 Proceeds from long-term borrowings    
 Dividend paid        
 Net cash used in financing activities  

–
 Net increase in cash and cash equivalents  

–
 Cash & cash equivalents at start of the period    
 Cash & cash equivalents at end of the period  

 –
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