LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

LM01 Introduction to Financial Statement Analysis

1. Introduction ...........................................................................................................................................................2
2. Financial Statement Analysis Framework .................................................................................................2
3. Scope of Financial Statement Analysis ........................................................................................................3
4. Regulated Sources of Information ................................................................................................................4
5. Comparison of IFRS with Alternative Financial Reporting Systems ...............................................7
6. Other Sources of Information .........................................................................................................................8
Summary................................................................................................................................................................... 10

This document should be read in conjunction with the corresponding reading in the 2023 Level I CFA®
Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

1. Introduction
Financial analysis is the process of examining a company’s performance. For this purpose,
financial reports are one of the most important sources of information available to a
financial analyst. A financial analyst must have a strong understanding of the information
provided in a company’s financial reports, notes, and supplementary information.

2. Financial Statement Analysis Framework

A generic financial statement analysis framework is summarized in the figure below. The
grey boxes represent phases of financial analysis while the white boxes represent outputs
from each phase.

Articulate the Purpose and Context of Analysis

In this step, we understand the purpose of the analysis. For example, an equity analyst
analyzes the financial reports in order to decide whether to invest in the stocks of the
company or not. On the other hand, a credit analyst looks at the company in a very different
light in order to judge whether it should be given a loan or not.
Next, the analyst defines the context which includes details such as the intended audience,
time frame, budget, and so on. Once the purpose and the context are defined, the analyst
compiles the specific questions to be answered by the analysis, decides on the content to be
prepared, and finalizes the timeline and the budget.
Collect Data
Next, the analyst collects data required to answer the questions compiled in the previous
step. The sources of data are financial reports and other information sources.
The output from this step includes organized financial statements, financial tables, and
completed questionnaires.

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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

Process Data
After collecting data, the analyst processes the data using appropriate analytical tools. This
involves:
• Making any adjustments to the financial statements to facilitate comparison. For
example, adjustments will be required to compare a company using IFRS with a
company using US GAAP.
• Creating graphs, ratios, common-size statements, etc.
The output from this step includes adjusted financial statements, common-size statements,
ratios, graphs, and forecasts.
Analyze/Interpret the Processed Data
The next step is to interpret the processed data and come up with a decision. For example,
an equity analyst may come up with a buy, sell, or hold decision.
Develop and Communicate Conclusions/Recommendations
Next, the analyst communicates the conclusions or recommendations in the appropriate
format. For example, an equity analyst will prepare a research report and send it to his firm’s
clients.
Follow-up
Conduct periodic reviews to check if the previous conclusions are still valid. Change the
conclusions/recommendations when necessary. For example, an equity analyst may send
quarterly updates on his initial buy, sell, or hold recommendation.
3. Scope of Financial Statement Analysis
In order to understand financial analysis, we first need to understand the difference between
the roles of financial reporting and financial statement analysis.
Financial reporting
The role of financial reporting is to provide information about a company’s performance
(income statement and cash flow statement), financial position (balance sheet) and changes
in financial position (statement of changes in equity).
Financial statement analysis
The role of financial statement analysis is to use the financial reports prepared by firms and
combine them with other sources of information to decide if you can invest in the equity of
the firm or lend money to the firm.

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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

4. Regulated Sources of Information

Standard-setting bodies
Standard-setting bodies are private sector organizations that help develop financial
reporting standards. The two important standard-setting bodies are:
• Financial Accounting Standards Board (FASB) – For the U.S. The standards developed
by FASB are called U.S. GAAP (Generally Accepted Accounting Principles).
• International Accounting Standards Board (IASB) – For the rest of the world. The
standards developed by IASB are called IFRS (International Financial Reporting
Standards).
Standard-setting bodies simply set the standards but they do not have the authority to
enforce the standards.
Regulatory Authorities
Regulatory authorities are government entities that have legal authority to enforce the
financial reporting standards. For example: Securities and Exchange Commission (SEC) – for
the U.S.
Regulatory authorities are also responsible for the regulation of capital markets under their
jurisdiction.
The International Organization of Securities Commissions (IOSCO)
Technically not being a regulatory authority, IOSCO still regulates a significant portion of the
world’s financial markets. (Think of it as an umbrella organization of regulatory authorities).
This organization has established objectives and principles to guide securities and capital
market regulation.
Core objectives
• Protect investors.
• Ensure fairness, efficiency, and transparency in markets.
• Reduce systemic risk.
Principles
• There should be full, accurate, and timely disclosure of financial results and risks.
• Financial statements should be of a high and internationally acceptable quality.
Primary Financial Statements
Instructor’s Note: The financial statements mentioned below will be covered in a lot more
detail in later readings. At this stage, you simply need to understand the basics.
The curriculum presents this information in terms of SEC filings – e.g. Forms 10-K, 20-F,
DEF-14A, 10-Q etc. You are not expected to memorize these forms. Also, exam questions are

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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

unlikely to test country-specific regulations. For these reasons, we have simplified the
explanation in this section for better comprehension.
The primary financial statements are the balance sheet, the income statement, the cash flow
statement, and the statement of changes in owners’ equity.
Balance Sheet (Statement of Financial Position)
The balance sheet reports the firm’s financial position at a specific point in time. It has the
following elements:
• Assets – What the company owns.
• Liabilities – What the company owes.
• Owners’ equity – What the shareholders of the company own. Depending on the form
of the organization, owners’ equity may be referred to as “partners’ capital” or
“shareholders’ equity” or “shareholders’ funds”, or “net assets”.
The relationship between the elements can be shown as:
Assets = Liabilities + Owners’ equity
The capital structure of a company represents the combination of liabilities and equity used
to finance its assets. Both financial position and capital structure are useful in credit analysis.
Income statement
The income statement reports the financial performance of the firm over a period of time. It
has the following elements:
• Revenues – Income generated by selling goods and services.
• Expenses – Costs incurred for producing goods and services.
• Net income – Resulting profit or loss.
The relationship between the elements can be shown as:
Net income = Revenues - Expenses
Cash flow statement
The cash flow statement reports the sources and uses of cash for the firm over a period of
time. It has the following elements:
• Operating cash flows – Cash flows from day-to-day activities.
• Investing cash flows - Cash flows associated with the acquisition and disposal of long-
term assets, such as property and equipment.
• Financing cash flows - Cash flows from activities related to obtaining or repaying
capital.

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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

Statement of changes in owner’s equity

It reports the changes in the owners’ investment in the firm over time. It has the following
elements:
• Paid in capital – Amount raised from owners.
• Retained earnings – Firm’s profits that have been retained (i.e., not paid out as
dividends).
Along with these required financial statements (mentioned above), a company typically
provides additional information in its financial reports. This includes footnotes,
management’s commentary, and auditor’s report.
Footnotes
They provide additional details about the information presented in financial statements.
This includes important information about the accounting methods, estimates, and
assumptions. They also contain information regarding acquisitions and disposals,
commitments and contingencies, legal proceedings, employee stock options and other
benefits, related party transactions and business, and geographic segments.
Management’s commentary or Management Discussion and Analysis (MD&A)
It provides an assessment of the data reported in the financial statements from the
management’s perspective. Examples of content include trends and significant events
affecting the company’s operations, liquidity and capital resources, off-balance sheet
obligations, and planned capital expenditures.
Auditor’s report
An audit is an independent review of a firm’s financial statements. It enables the auditor to
express an opinion on the fairness and reliability of the financial reports. An audit report
can contain one of the following opinions:
• Unqualified Opinion - Reasonable assurance that financial statements are fairly
presented. This is also referred to as an “unmodified” or a “clean” opinion. (This is the
opinion that you would like to see.)
• Qualified Opinion - Some misstatement or exception to accounting standards.
• Adverse Opinion - Financial statements materially depart from accounting standards
and are not presented fairly.
If the auditor is not able to issue an opinion for reasons such as a scope limitation, a
disclaimer of opinion is issued.
For listed companies, the audit report also includes a discussion of Key Audit Matters
(international) and Critical Audit Matters (US). Key Audit Matters and Critical Audit Matters
include issues having a higher risk of misstatement, involving significant management
judgment and estimates.

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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

Other sources:
• Interim reports – Quarterly or semiannual reports prepared by the firm. These reports
are not audited.
• Proxy statements – Statements distributed to shareholders about matters that are to
be put to a vote, e.g. management and director compensation.
5. Comparison of IFRS with Alternative Financial Reporting Systems
A significant percentage of listed companies use either IFRS or US GAAP. An analyst must be
cautious when comparing financial measures between companies reporting under IFRS and
companies reporting under US GAAP. If needed, specific adjustments need to be made to
achieve comparability.
US GAAP uses standards issued by FASB while IFRS uses standards issued by IASB. While the
two organizations are working towards convergence, significant differences still remain.
Exhibit 6 from the curriculum presents some of the differences.
Basis for Comparison US GAAP IFRS
Developed by Financial Accounting Standards International Accounting
Board (FASB) Standards Board (IASB)
Based on Rules Principles
Interest paid Cash Flows from Operating Cash Flows from Financing
Activities Activities or Cash Flows
from Operating Activities
Inventory valuation First in, First out (FIFO); Last in, FIFO and Weighted Average
First out (LIFO); and Weighted Method
Average Method
Development cost Treated as an expense Capitalized, only if certain
conditions are satisfied
Reversal of Inventory Prohibited Permissible, if specified
Write-down conditions are met
Monitoring Developments in Financial Reporting Standards
Analysts must be aware that reporting standards are evolving rapidly. They need to monitor
developments in financial reporting and assess their implications for security analysis and
valuation.
A financial analyst can remain aware of developments in financial reporting standards by
monitoring three sources:
• new products or transactions
• actions of standard setters and groups representing users of financial statements
• company’s disclosures regarding critical accounting policies and estimates.

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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

New Products or Types of Transactions

New products or transactions can emerge as a result of economic events such as new
businesses (e.g. fintech) or a newly developed financial instrument (e.g. crypto currencies).
Analysts should investigate whether these products or transactions were created for the
purpose of 'window dressing' financial reports.
If needed, an analyst can obtain additional information from the company's management,
which should be able to describe the economic purpose, financial statement reporting,
significant estimates, judgments used in determining the reporting, and future cash flow
implications for these items.
Evolving Standards and the Role of CFA Institute
The IASB and FASB both provide extensive information on their websites about new
standards and proposed changes to the standards. Furthermore, both bodies seek feedback
from the financial analyst community on how the standards can be improved further.
CFA Institute actively works in supporting improvements to financial reporting. CFA
Institute volunteers serve on several liaison committees that meet on a regular basis to make
recommendations to the IASB and FASB.
6. Other Sources of Information
In addition to the information required by regulatory authorities, analysts can also obtain
information from the following sources.
• Issuer sources (other than regulatory filings such as annual and quarterly reports and
proxy statements)
o Earnings call
o Presentations and events, such as investor days.
o Press releases
o Discussion with management, investor relations, or other company personnel.
o Company website
• Public third-party sources
o Free industry whitepapers or analyst reports from a consultancy
o Economic or industry indicators from governments and other organizations, e.g.
retail sales and price indexes.
o General news outlets
o Industry-specific news outlets
o Social media
• Proprietary third-party sources
o Analyst reports and communications
o Reports and data from platforms such as Bloomberg
o Reports and data from consultancies such as Rystad for the energy industry

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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

• Proprietary primary research

o Surveys, conversations, product comparisons, and other studies commissioned by
the analyst or conducted directly.

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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

Summary
LO: Describe the steps in the financial statement analysis framework.
The financial statement analysis framework consists of the following six steps:
1. Define the purpose and context of the analysis.
• Define the purpose and context of the analysis based on your function, client
inputs, and organizational guidelines.
• Determine the time frame and the resources available for the task.
2. Collect data.
• Collect data from financial statements and other information sources.
3. Process the data.
• Make adjustments to financial statements.
• Create graphs, ratios, common-sizes statements, etc.
4. Analyze and interpret the data.
5. Develop and communicate conclusions and recommendations.
6. Follow up.
• Conduct periodic reviews to check if previous conclusions are still valid.
LO: Describe the roles of financial statement analysis.
The role of financial reporting is to provide information about a company’s performance
(income statement and cash flow statement), financial position (balance sheet) and changes
in financial position (statement of changes in equity).
The role of financial statement analysis is to use the financial reports prepared by firms and
combine them with other sources of information to decide if you can invest in the equity of
the firm or lend money to the firm.
LO: Describe the importance of regulatory filings, financial statement notes and
supplementary information, management’s commentary, and audit reports.
The balance sheet reports the firm’s financial position at a specific point in time. It shows the
firm’s assets, liabilities, and owners’ equity.
The income statement reports the financial performance of the firm over a period of time. It
shows the firm’s revenues, expenses, and net income.
The cash flow statement reports the sources and uses of cash for the firm over a period of
time. It shows the firm’s operating, investing, and financing cash flows.
Statement of changes in owner’s equity reports the changes in the owners’ investment in the
firm over time. It shows the firm’s paid in capital and retained earnings.
The notes (also called footnotes) are important as they disclose information about the
accounting policies, methods, and estimates used to prepare the financial statements. They

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LM01 Introduction to Financial Statement Analysis 2024 Level I Notes

contain important information regarding acquisitions and disposals, commitments and

contingencies, legal proceedings, employee stock options and other benefits, related party
transactions and business, and geographic segments.
Management’s commentary comprises of subjective information where management is
presenting its view and interpretation of the data it has reported. Examples of content
include trends and significant events affecting the company’s operations, liquidity and
capital resources, off-balance sheet obligations, and planned capital expenditures.
An audit is an independent review of a firm’s financial statements. It enables the auditor to
express an opinion on the fairness and reliability of the financial reports. An audit report can
contain one of the following opinions:
• Unqualified Opinion - Reasonable assurance that financial statements are fairly
presented.
• Qualified Opinion - Some misstatement or exception to accounting standards.
• Adverse Opinion - Financial statements are not presented fairly.
LO: Describe implications for financial analysis of alternative financial reporting
systems and the importance of monitoring developments in financial reporting
standards.
Differences still exist between IFRS and US GAAP that affect financial reporting. Analysts
must be aware of the areas where accounting standards have not converged.
Analysts must be aware that reporting standards are evolving rapidly. They need to monitor
developments in financial reporting and assess their implications for security analysis and
valuation.
LO: Describe information sources that analysts use in financial statement analysis
besides annual and interim financial reports.
In addition to the information required by regulatory authorities, analysts can also obtain
information from the following sources:
• Earnings calls
• Investor day events
• Press releases
• Company website and company visits
• Speaking with the management
• Industry white papers
• Analyst reports
• Economic information from government
• Analysts can also generate their own information through surveys, conversations, and
product evaluations.

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