CFA Level 1 β Financial Statement Analysis
Intuition-First Study Guide Β· All 12 Readings
Reading 27
Introduction to Financial Statement Analysis
The six-step framework, key reports, and who sets the rules.
The Six-Step FSA Framework
Before diving into any numbers, an analyst follows a structured process. Think of it as a research methodology β you wouldn't just grab random ratios.
| Step | What You Do | Why It Matters |
|---|---|---|
| 1. State objective | Define the question (creditworthiness? equity valuation?) | Different objectives require different analysis |
| 2. Gather data | Collect financial statements, industry data, management commentary | Garbage in, garbage out |
| 3. Process data | Calculate ratios, create common-size statements, make adjustments | Raw data isn't useful without processing |
| 4. Analyze & interpret | Draw conclusions from processed data | Numbers tell a story β this is where you read it |
| 5. Report | Communicate findings; comply with Code & Standards | Analysis is useless if not communicated well |
| 6. Update | Periodically repeat, revise recommendations | Companies change; so should your analysis |
Key Reports and Information Sources
Financial statements are prepared according to standards set by the IASB (IFRS, used globally) or the FASB (U.S. GAAP, used in the United States). Regulatory authorities like the SEC enforce compliance.
Footnotes are audited and often more important than the statements themselves. They reveal accounting methods, assumptions, estimates, contingencies, and related-party transactions. Always read them.
| Source | What It Contains | Exam Tip |
|---|---|---|
| Financial statements | Income statement, balance sheet, cash flow, equity changes | The core β always start here |
| Footnotes | Accounting methods, estimates, contingencies | Audited β treat with high confidence |
| MD&A | Management's discussion of results, trends, liquidity | NOT audited β management's spin |
| Auditor's report | Unqualified, qualified, adverse, or disclaimer | Unqualified = "clean" opinion |
| Proxy statement | Board elections, executive compensation | Filed with SEC; good governance info |
The Three Financial Statements β Structure & Interconnections
Every public company produces three core financial statements. They're not independent β they form a closed loop where each feeds into the others.
| Statement | What It Answers | Time Coverage | Key Equation |
|---|---|---|---|
| Income Statement | How much did the company earn? | Over a period (e.g., fiscal year) | Revenue β Expenses = Net Income |
| Balance Sheet | What does the company own and owe at this moment? | At a point in time (snapshot) | Assets = Liabilities + Equity |
| Cash Flow Statement | Where did cash come from and go? | Over a period (same as IS) | ΞCash = CFO + CFI + CFF |
Big Picture β The Three-Statement Loop
The three statements form a closed circuit. Net Income from the Income Statement flows into Retained Earnings on the Balance Sheet (IS β BS). The Cash Flow Statement starts with Net Income and reconciles it to actual cash collected (IS β CFS). The Ending Cash on the Cash Flow Statement equals the Cash line on the Balance Sheet (CFS β BS). Changes in Balance Sheet accounts β receivables, inventory, payables β explain CFO adjustments (BS β CFS).
Four Bridges Between the Statements
| Bridge | From | To | What Connects |
|---|---|---|---|
| IS β BS | Income Statement | Balance Sheet | Net Income increases Retained Earnings: Ending RE = Beginning RE + NI β Dividends. D&A expense reduces the carrying value of PP&E and intangibles. |
| IS β CFS | Income Statement | Cash Flow Statement | Net Income is the starting point for CFO (indirect method). Non-cash items (D&A, unrealized gains) are reversed; accrual items are converted to cash. |
| CFS β BS | Cash Flow Statement | Balance Sheet | Ending cash on CFS = Cash & equivalents on Balance Sheet. CapEx (CFI outflow) increases PP&E. Debt issued (CFF inflow) increases long-term liabilities. |
| BS β CFS | Balance Sheet | Cash Flow Statement | Period-over-period changes in working capital accounts drive CFO adjustments: βAR subtracts from CFO (earned but not collected); βAP adds to CFO (incurred but not paid). |
A company earns $100 profit but collects only $70 in cash β the rest is in receivables. Income Statement shows $100 Net Income. Balance Sheet shows $30 in AR (an asset increase). Cash Flow Statement reconciles: $100 NI β $30 (increase in AR) = $70 CFO. That $70 is also the change in the Cash line on the Balance Sheet.
π― Likely Exam Question
Which step of the FSA framework involves calculating ratios, creating common-size statements, and making adjustments to financial data?
Answer: Step 3 β Process the data. This is the "crunch the numbers" step. Don't confuse it with Step 4 (analyze/interpret), which draws conclusions from the processed data.
π― Likely Exam Question
An auditor issues a qualified opinion. This most likely means:
Answer: The financial statements make specific exceptions to applicable accounting standards, and the auditor has explained the effects. It's a yellow flag β not as bad as adverse, but not clean either.
Reading 28
Analyzing Income Statements
Revenue recognition, expense matching, EPS β the most tested FSA reading.
Income Statement Structure
The income statement flows top-down as a waterfall β each layer subtracts costs until you reach net income. Understanding the structure helps you immediately identify where profitability is being eroded.
Top Line Revenue (Net Sales) $X,XXX
β Returns, discounts, and allowances (XXX)
= Net Revenue $X,XXX
Gross Profit β Cost of Goods Sold (COGS) (X,XXX)
= Gross Profit $X,XXX β Gross Profit Margin = Gross Profit / Revenue
Operating Income β Selling, General & Administrative (SG&A) (XXX)
β Research & Development (R&D) (XXX)
β Depreciation & Amortization (D&A) (XXX)
β Other operating expenses / impairments (XX)
= Operating Income (EBIT) $X,XXX β Operating Profit Margin = EBIT / Revenue
Pre-Tax Income + Interest & investment income XXX
β Interest expense (XXX)
+/β Non-operating gains / losses Β±XX
= Pre-Tax Income (EBT) $X,XXX
Bottom Line β Income Tax Expense (XXX)
= Net Income $X,XXX β Preferred Dividends (XX)
= Earnings available to common shareholders $X,XXX
Γ· Weighted avg. shares outstanding X,XXX
= Earnings Per Share (EPS) $X.XX
EBITDA = EBIT + D&A. It's not a GAAP measure but is widely used as a proxy for operating cash generation. Don't confuse EBITDA with actual cash flow β it ignores working capital changes, taxes, and capital expenditures.
The income statement uses the accrual basis β revenue is recorded when earned, expenses when incurred, regardless of when cash moves. This is why net income often differs significantly from CFO. That gap is the whole reason the Cash Flow Statement exists.
Revenue Recognition β The Five-Step Model Critical
Under converged IFRS/U.S. GAAP standards, revenue is recognized using a five-step process:
- Identify the contract(s) with a customer
- Identify the separate performance obligations in the contract
- Determine the transaction price
- Allocate the price to the performance obligations
- Recognize revenue when (or as) a performance obligation is satisfied
Revenue is recognized when earned, not when cash is received. If you sell a magazine subscription and get paid upfront, you only recognize revenue as each issue is delivered β the rest sits as "unearned revenue" (a liability).
If payment is received BEFORE goods/services are delivered β create an unearned revenue liability. Revenue recognized only as obligations are satisfied.
Expense Recognition β Capitalize vs. Expense
The decision to capitalize or expense a cost is one of the most impactful accounting choices. Capitalizing spreads the cost over multiple periods via depreciation; expensing hits the income statement immediately.
Capitalize (Year 1)
- Higher net income (Year 1)
- Higher assets & equity
- Higher CFO (cost in CFI)
- Higher ROE & ROA initially
Expense (Year 1)
- Lower net income (Year 1)
- Lower assets & equity
- Lower CFO (cost in CFO)
- Lower ROE & ROA initially
Under IFRS, research costs are expensed; development costs may be capitalized if criteria are met. Under U.S. GAAP, BOTH research and development costs are expensed (except software for sale, once technically feasible).
Earnings Per Share (EPS) Critical
\[ \text{Basic EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Common Shares}} \]
Diluted EPS β Three Types of Dilutive Securities
| Security | Numerator Adjustment | Denominator Adjustment | Dilutive If⦠|
|---|---|---|---|
| Stock options/warrants | None | Treasury stock method: net new shares = options β (proceeds / avg price) | Exercise price < average market price |
| Convertible preferred | Add back preferred dividends | Add shares from conversion | Per-share impact < basic EPS |
| Convertible bonds | Add back after-tax interest | Add shares from conversion | Per-share impact < basic EPS |
π― Likely Exam Question (Calculation)
XXX Corp. has net income of $1.2M, 500,000 shares outstanding, and 100,000 options with exercise price $15. Average market price is $20. Calculate diluted EPS.
Answer: Treasury stock method: 100,000 shares created. Proceeds = 100,000 Γ $15 = $1.5M. Shares repurchased = $1.5M / $20 = 75,000. Net new shares = 25,000. Diluted EPS = $1,200,000 / 525,000 = $2.29 (vs. basic EPS of $2.40). Options are dilutive because exercise price ($15) < average price ($20).
π― Likely Exam Question
A company has basic EPS of $1.25. Its convertible bonds would add $70,000 after-tax interest and 100,000 shares. Are the bonds dilutive?
Answer: Per-share impact = $70,000 / 100,000 = $0.70. Since $0.70 < $1.25 basic EPS, the bonds ARE dilutive and must be included. If per-share impact exceeded basic EPS, they'd be antidilutive and excluded.
Common-Size Income Statements
A vertical common-size income statement expresses every line item as a percentage of revenue, eliminating size effects. This allows comparison across time and across firms of different sizes.
\[ \text{Gross Profit Margin} = \frac{\text{Revenue} - \text{COGS}}{\text{Revenue}} \qquad \text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}} \]
Reading 29
Analyzing Balance Sheets
Assets = Liabilities + Equity β but the devil is in the measurement.
Balance Sheet Structure Overview Critical
The balance sheet is a snapshot at a single point in time. It's organized by liquidity β most liquid assets and nearest-due liabilities come first. The fundamental identity must always hold:
Assets = Liabilities + Shareholders' Equity
ASSETS β What the company owns or controls
Current Assets (convert to cash within 1 year)
Cash & cash equivalents
Short-term investments / marketable securities
Accounts receivable (net of allowance)
Inventory
Prepaid expenses & other current assets
Non-Current Assets (benefit beyond 1 year)
PP&E (net of accumulated depreciation)
Right-of-use assets (finance & operating leases)
Intangible assets (patents, trademarks, licenses)
Goodwill
Long-term investments / equity method investments
Deferred tax assets (DTA)
LIABILITIES + EQUITY β How the assets are funded
Current Liabilities (due within 1 year)
Accounts payable
Accrued liabilities (wages, interest, taxes)
Short-term debt / commercial paper
Current portion of long-term debt
Unearned (deferred) revenue
Non-Current Liabilities (due beyond 1 year)
Long-term debt / bonds payable
Deferred tax liabilities (DTL)
Lease obligations (finance leases)
Pension / post-retirement obligations
Shareholders' Equity
Common stock + Additional paid-in capital (APIC)
Retained earnings
Accumulated other comprehensive income (AOCI)
Treasury stock (contra-equity β reduces total equity)
Retained Earnings bridges the balance sheet and income statement: Ending RE = Beginning RE + Net Income β Dividends Declared. Every dollar of net income that isn't paid as a dividend accumulates here. This is why a company can grow its balance sheet without issuing new stock β profits compound inside the equity section.
Working capital = Current Assets β Current Liabilities. It measures short-term liquidity cushion. A negative working capital means current liabilities exceed current assets β which is fine for some businesses (supermarkets get paid before paying suppliers) but a red flag for others.
Intangible Assets
| Type | Treatment | Key Rule |
|---|---|---|
| Internally created intangibles | Expensed as incurred | IFRS: research expensed, development may be capitalized. U.S. GAAP: both expensed |
| Purchased intangibles (finite life) | Capitalized, amortized | Similar to tangible assets |
| Purchased intangibles (indefinite life) | Not amortized; tested for impairment annually | Includes goodwill |
Goodwill
\[ \text{Goodwill} = \text{Purchase Price} - \text{Fair Value of Identifiable Net Assets} \]
Goodwill only arises from acquisitions β you cannot create goodwill internally and put it on your balance sheet. It represents the premium the buyer paid for things like brand reputation, customer loyalty, and expected synergies. Goodwill is never amortized, but must be tested for impairment at least annually.
Measurement of Financial Assets
| Classification | Balance Sheet | Unrealized Gains/Losses |
|---|---|---|
| Held-to-maturity (debt only) | Amortized cost | Not recognized |
| Available-for-sale / FVOCI | Fair value | Other comprehensive income (OCI) |
| Trading / FVPL | Fair value | Income statement (P&L) |
Liquidity & Solvency Ratios from the Balance Sheet
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \qquad \text{Quick Ratio} = \frac{\text{Cash + Marketable Securities + Receivables}}{\text{Current Liabilities}} \]
\[ \text{Debt-to-Equity} = \frac{\text{Total Debt}}{\text{Total Equity}} \qquad \text{Financial Leverage} = \frac{\text{Total Assets}}{\text{Total Equity}} \]
π― Likely Exam Question
Company A has a higher current ratio but lower quick ratio than Company B. What does this imply?
Answer: Company A has relatively more inventory than Company B. The quick ratio excludes inventory from current assets. A high current ratio but low quick ratio suggests potential liquidity concerns if inventory is illiquid or obsolete.
Reading 30
Analyzing Statements of Cash Flows I
Cash is king β accruals lie, but cash flows don't.
Three Sections of the Cash Flow Statement
| Section | What It Captures | Examples (U.S. GAAP) |
|---|---|---|
| CFO (Operating) | Cash from core business operations | Cash from customers, cash paid to suppliers, interest paid, taxes paid, dividends received |
| CFI (Investing) | Cash for long-term asset purchases/sales | Purchase/sale of PP&E, purchase/sale of investments |
| CFF (Financing) | Cash from/to capital providers | Debt issued/repaid, equity issued/repurchased, dividends paid |
Cash Flow Statement Structure
Unlike the income statement (accrual basis), the cash flow statement tells you what actually happened to cash during the period. Its ending balance must equal the cash line on the balance sheet.
Operating Activities (CFO) β Core business cash generation Net Income (indirect method starting point) $X,XXX
+ Depreciation & amortization (non-cash add-back) XXX
+ Amortization of deferred revenue / intangibles XX
β Unrealized gains on investments (non-cash) (XX)
+ Unrealized losses on investments (non-cash) XX
β Increase in accounts receivable (XXX) β earned but not collected
β Increase in inventory (XXX) β cash tied up in stock
+ Increase in accounts payable XXX β owe but haven't paid yet
+ Increase in deferred tax liabilities XX
= Cash Flow from Operations (CFO) $X,XXX
Investing Activities (CFI) β Long-term asset transactions β Capital expenditures (CapEx: purchase of PP&E) (X,XXX)
+ Proceeds from sale of PP&E or investments XXX
β Acquisitions (net of cash acquired) (X,XXX)
+ Proceeds from sale of business segments XXX
+/β Net purchases/maturities of investments Β±XXX
= Cash Flow from Investing (CFI) $(X,XXX)
Financing Activities (CFF) β Capital structure transactions + Proceeds from long-term debt issuance X,XXX
β Repayment of long-term debt / bonds (X,XXX)
+ Proceeds from equity issuance (new shares) XXX
β Share repurchases / buybacks (XXX)
β Dividends paid to shareholders (XXX)
= Cash Flow from Financing (CFF) $(X,XXX)
Net Change in Cash Net Change in Cash = CFO + CFI + CFF $Β±XXX Beginning Cash & equivalents (from prior balance sheet) X,XXX
+ Net Change in Cash Β±XXX
= Ending Cash & equivalents (β Balance Sheet asset) $X,XXX
The ending cash balance on the cash flow statement must equal the "Cash & cash equivalents" line on the balance sheet. If they don't match, something is wrong. This is the most direct hard-wired link between the two statements.
Under U.S. GAAP: Interest paid = CFO, Dividends paid = CFF, Interest/dividends received = CFO. Under IFRS: Companies have flexibility β interest/dividends paid can be CFO or CFF; interest/dividends received can be CFO or CFI.
Direct vs. Indirect Method Critical
Direct Method
- Shows actual cash receipts and payments
- Starts with cash from customers
- Preferred by standard setters
- Rarely used in practice
Indirect Method
- Starts with net income
- Adjusts for noncash items and working capital changes
- Shows why NI β CFO
- Used by most companies
Indirect Method Adjustments
\[ \text{CFO} = \text{Net Income} + \text{Noncash Charges} - \text{Working Capital Investment} \]
| Adjustment | Add or Subtract? | Why |
|---|---|---|
| Depreciation/amortization | Add back | Noncash charge that reduced NI |
| Gain on asset sale | Subtract | Gain was in NI but cash is in CFI |
| Loss on asset sale | Add back | Loss was in NI but cash is in CFI |
| Increase in receivables | Subtract | Revenue earned but not collected = use of cash |
| Decrease in inventory | Add | Cash freed up from selling inventory |
| Increase in accounts payable | Add | Expenses incurred but not yet paid = source of cash |
| Increase in deferred tax liability | Add | Tax expense > tax paid = noncash tax |
Think of each working capital adjustment this way: if an operating asset INCREASED, the company "used" cash to build that asset β subtract. If an operating liability INCREASED, the company "borrowed" from suppliers β add. Just reverse the logic for decreases.
π― Likely Exam Question (Calculation)
Net income is $78,000. Receivables increased $52,000. Payables increased $29,000. Depreciation was $12,000. Unrealized gain on trading securities was $15,000. What is CFO?
Answer: CFO = $78,000 + $12,000 (depreciation) β $15,000 (unrealized gain) β $52,000 (β receivables) + $29,000 (β payables) = $52,000.
Direct Method β Calculating Cash Flow Items
The direct method shows actual cash receipts and payments. Standard setters prefer it, but most companies use indirect. On the exam, you must be able to convert accrual line items to cash using related balance sheet changes.
The mechanics: take the accrual income statement item, then adjust for the change in the related balance sheet account. An increase in an asset account means cash was used; an increase in a liability means cash was saved.
| Cash Item | Formula | Logic |
|---|---|---|
| Cash received from customers | Revenue β Ξ Accounts Receivable | β AR means revenue earned but not collected β less cash received |
| Cash paid to suppliers | Step 1: Purchases = COGS + Ξ Inventory Step 2: Cash Paid = Purchases β Ξ Accounts Payable |
β Inventory means more bought than sold. β AP means not yet paid β reduces cash outflow |
| Cash paid to employees | Salaries Expense β Ξ Salaries Payable | β Payable means accrued but unpaid β less cash out |
| Cash paid for interest | Interest Expense β Ξ Interest Payable | Same logic as salaries |
| Cash paid for taxes | Tax Expense β Ξ Taxes Payable β Ξ Deferred Tax Liability | β DTL means tax expensed but not yet paid to government |
Worked Examples
| Scenario | Calculation | Result |
|---|---|---|
| Revenue = $500,000; AR β $20,000 | Cash Received = $500,000 β $20,000 | $480,000 |
| COGS = $300,000; Inventory β $10,000; AP β $5,000 | Purchases = $300,000 + $10,000 = $310,000 Cash Paid = $310,000 β $5,000 |
$305,000 |
Converting Indirect to Direct Method
Both methods yield the same CFO total β they just present it differently. To convert, work through each income statement line item and strip out the accrual effects.
| Step | What You Do | Example |
|---|---|---|
| 1. Start with accrual IS item | Take the revenue or expense line as reported | Revenue = $500,000 |
| 2. Remove non-cash components | Exclude D&A, unrealised gains/losses β these have no cash counterpart | Depreciation embedded in COGS? Strip it out |
| 3. Adjust for BS account changes | Apply Ξ in the related working capital account (AR, Inventory, AP, Payables) | AR β $20,000 β Cash received = $480,000 |
Think of the indirect method as a reconciliation from profit to cash. The direct method is a re-presentation that shows you the same cash total but broken into customer receipts, supplier payments, employee payments, etc. Same number, different story.
π― Likely Exam Question (Calculation)
A company reports: Revenue $800,000; AR decreased $30,000; COGS $500,000; Inventory increased $15,000; AP decreased $10,000. Calculate (a) cash received from customers and (b) cash paid to suppliers.
(a) Cash received = $800,000 β (β$30,000) = $830,000 (AR fell β collected more than earned).
(b) Purchases = $500,000 + $15,000 = $515,000. Cash paid = $515,000 β (β$10,000) = $525,000 (AP fell β paid off old payables).
(b) Purchases = $500,000 + $15,000 = $515,000. Cash paid = $515,000 β (β$10,000) = $525,000 (AP fell β paid off old payables).
Reading 31
Analyzing Statements of Cash Flows II
Free cash flow, quality of earnings, and cash-based performance ratios.
Free Cash Flow Critical
\[ \text{FCFF} = \text{NI} + \text{NCC} + \text{Int}(1-t) - \text{FCInv} - \text{WCInv} \]
\[ \text{FCFF} = \text{CFO} + \text{Int}(1-t) - \text{FCInv} \]
\[ \text{FCFE} = \text{CFO} - \text{FCInv} + \text{Net Borrowing} \]
FCFF is the cash available to ALL investors (debt + equity). FCFE is the cash available only to equity holders β after paying interest and adjusting for net debt. If a company consistently generates positive FCFF but negative FCFE, it's servicing too much debt.
Cash Flow Patterns β What They Tell You
| CFO | CFI | CFF | Interpretation |
|---|---|---|---|
| + | β | β | Mature, healthy company: funding investments and repaying debt from operations |
| + | β | + | Growing company: operations profitable but raising capital for expansion |
| β | β | + | Growth or startup: burning cash, investing heavily, raising capital |
| β | + | + | Distressed: selling assets and raising cash to fund losses |
π― Likely Exam Question
A company has CFO of $400M, interest expense of $50M (tax rate 25%), and capital expenditures of $200M. What is FCFF?
Answer: FCFF = CFO + Int(1βt) β FCInv = $400M + $50M(0.75) β $200M = $400M + $37.5M β $200M = $237.5M.
Reading 32
Analysis of Inventories
FIFO vs. LIFO β one of the most-tested areas in all of FSA.
FIFO vs. LIFO β Assuming Rising Prices Critical
| Item | FIFO | LIFO |
|---|---|---|
| COGS | Lower (older, cheaper costs) | Higher (newer, expensive costs) |
| Ending inventory (BS) | Higher (recent costs) | Lower (old costs) |
| Gross profit & NI | Higher | Lower |
| Taxes paid | Higher | Lower β better cash flow |
| Current ratio | Higher (higher inventory) | Lower |
| Inventory turnover | Lower | Higher (high COGS / low inventory) |
| Debt-to-equity | Lower (higher equity) | Higher |
FIFO gives a better balance sheet (inventory at recent cost). LIFO gives a better income statement (COGS at recent cost). In a real sense, LIFO cash flows are superior because taxes are lower. If prices are falling, all effects reverse.
Inventory Valuation β Lower of Cost or NRV
Under IFRS, inventory is reported at the lower of cost or net realizable value (NRV = expected selling price β completion and selling costs). Write-ups are allowed under IFRS (limited to prior write-downs). Under U.S. GAAP, no write-ups are allowed.
Core Rules by Standard & Method
| Standard / Method | Inventory Measurement |
|---|---|
| IFRS (all methods) | Lower of cost and NRV |
| U.S. GAAP β FIFO or weighted average | Lower of cost and NRV |
| U.S. GAAP β LIFO or retail inventory method | Lower of cost or market |
What "Market" Means Under U.S. GAAP (LIFO / Retail)
Market is defined as the middle value of three amounts:
\[ \text{Market} = \text{median}(\text{Replacement Cost},\ \text{NRV},\ \text{NRV} - \text{Normal Profit Margin}) \]
Inventory is then carried at:
\[ \text{Inventory Value} = \min(\text{Cost},\ \text{Market}) \]
The ceiling is NRV (prevents overstating inventory above what can be recovered). The floor is NRV β normal profit margin (prevents understating and creating an artificial future profit). Market cannot exceed the ceiling or fall below the floor β replacement cost is used only if it falls within that range.
LIFO Liquidation
A LIFO liquidation occurs when a LIFO firm sells more inventory than it buys β digging into old, cheap layers. This artificially inflates COGS savings and boosts profit margins unsustainably. The LIFO reserve will shrink, which is your red flag in the footnotes.
π― Likely Exam Question
During rising prices, compared to LIFO, a firm using FIFO will have a:
Answer: Higher current ratio. FIFO inventory on the balance sheet reflects more recent (higher) costs β higher current assets β higher current ratio. FIFO also produces lower COGS, higher gross margin, but higher taxes.
Reading 33
Analysis of Long-Term Assets
Capitalization, depreciation, impairment β how PP&E and intangibles age on the books.
Impairment β IFRS vs. U.S. GAAP Critical
| Feature | IFRS | U.S. GAAP |
|---|---|---|
| Test | Carrying value > recoverable amount | Step 1: Carrying value > undiscounted future cash flows |
| Write-down to | Recoverable amount (higher of fair value less selling costs OR value in use) | Fair value (or discounted CF if FV unknown) |
| Reversal allowed? | Yes (limited to original loss) | No (for assets held for use) |
Impairment charges are a backdoor for earnings management. Management can time them during "bad" years (big bath), making future years look better β lower asset base means lower depreciation, higher ROA and ROE going forward. Watch for clusters of impairments when new management takes over.
Useful Disclosure Ratios
\[ \text{Average Age} = \frac{\text{Accumulated Depreciation}}{\text{Annual Depreciation Expense}} \]
\[ \text{Total Useful Life} = \frac{\text{Gross PP\&E}}{\text{Annual Depreciation Expense}} \]
\[ \text{Remaining Life} = \frac{\text{Net PP\&E}}{\text{Annual Depreciation Expense}} \]
π― Likely Exam Question
Under IFRS, equipment has a carrying value of $800,000, value in use of $785,000, and fair value less selling costs of $760,000. Is it impaired, and by how much?
Answer: Recoverable amount = max($785,000, $760,000) = $785,000. Since carrying value ($800,000) > recoverable amount ($785,000), the asset is impaired. Impairment loss = $800,000 β $785,000 = $15,000.
Reading 34
Topics in Long-Term Liabilities and Equity
Leases, pensions, and how debt really works on the balance sheet.
Lease Classification β Finance vs. Operating
A lease is a finance lease if it meets ANY of five criteria: (1) ownership transfers, (2) bargain purchase option likely exercised, (3) lease term covers most of asset's life, (4) PV of payments β₯ asset's fair value, (5) asset is specialized. Otherwise, it's an operating lease.
Lessee Accounting β Both types put assets and liabilities on the balance sheet
| Feature | Finance Lease | Operating Lease (U.S. GAAP) |
|---|---|---|
| Balance sheet | ROU asset + lease liability | ROU asset + lease liability (equal at all times) |
| Income statement | Interest expense + amortization (separately) | Single lease expense = payment amount |
| Early-year expense | Higher (front-loaded interest) | Constant (straight-line) |
| Total expense | Same over full life | Same over full life |
| Cash flow statement | Interest β CFO, Principal β CFF | Entire payment β CFO |
Under IFRS, there is no distinction in lessee accounting β both finance and operating leases create ROU assets/liabilities and report interest + amortization separately (like finance lease treatment). The U.S. GAAP operating lease treatment (single expense, equal ROU and liability) is unique to U.S. GAAP.
π― Likely Exam Question
Compared to a finance lease, an operating lease under U.S. GAAP in Year 1 will report:
Answer: Lower total expense in Year 1. Finance leases have front-loaded expense (high interest + amortization early on). Operating leases report a constant, straight-line lease expense each year. Same total over the lease life, but different timing.
Defined Benefit Pensions
Companies report a net pension asset or liability: the fair value of plan assets minus the estimated pension obligation (PBO). Three components of pension cost: service cost (CFO), interest cost, and expected return on plan assets. Actuarial gains/losses and past service costs go through OCI under IFRS.
Reading 35
Analysis of Income Taxes
DTAs, DTLs, and the gap between what companies tell the tax authorities and what they tell you.
The Core Relationship Critical
\[ \text{Income Tax Expense} = \text{Taxes Payable} + \Delta\text{DTL} - \Delta\text{DTA} \]
Think of tax expense as what the company SHOULD owe based on accounting income. Taxes payable is what they ACTUALLY owe the government right now. The difference creates deferred tax items β essentially IOUs to or from the tax authorities.
DTAs and DTLs β When Are They Created?
| Deferred Tax Item | Created When⦠| Classic Example |
|---|---|---|
| DTL (future tax owed) | Tax expense > taxes payable (taxable income < pretax income) | Accelerated depreciation for tax, straight-line for accounting β more depreciation on tax return early β less tax now, more later |
| DTA (future tax saving) | Taxes payable > tax expense (taxable income > pretax income) | Warranty provisions: expense recognized in income statement before tax deduction is allowed; tax loss carryforwards |
Permanent differences (e.g., tax-exempt municipal bond interest, non-deductible fines) do NOT create DTAs or DTLs. They cause the effective tax rate to differ from the statutory rate, but they never reverse.
Three Tax Rates to Know
\[ \text{Statutory Rate} = \text{Rate set by law} \]
\[ \text{Effective Rate} = \frac{\text{Income Tax Expense}}{\text{Pretax Income}} \]
\[ \text{Cash Tax Rate} = \frac{\text{Cash Taxes Paid}}{\text{Pretax Income}} \]
Valuation Allowance (U.S. GAAP)
If a company doubts it will have enough future taxable income to use its DTAs, it must create a valuation allowance (contra asset). Increasing the valuation allowance reduces the net DTA, increases tax expense, and decreases net income. This is a potential earnings management tool.
π― Likely Exam Question
A company increases its valuation allowance against DTAs. What is the effect on income tax expense and net income?
Answer: Increasing the valuation allowance reduces the net DTA β increases income tax expense β decreases net income. This signals that management is less confident about future profitability.
π― Likely Exam Question
How should an analyst treat a DTL that is not expected to reverse due to growing capital expenditures?
Answer: Treat it as equity, not as a liability. If the company keeps investing in new assets, accelerated tax depreciation on new assets keeps the DTL growing β it effectively never reverses. Reclassifying it to equity lowers leverage ratios.
Reading 36
Financial Reporting Quality
How to detect when companies stretch, bend, or break the rules.
Spectrum of Financial Reporting Quality
| Quality Level | Description |
|---|---|
| GAAP-compliant, decision-useful | Highest quality β sustainable, adequate returns |
| GAAP-compliant but low quality | Within rules but aggressive choices that inflate earnings |
| Non-compliant (aggressive) | Biased choices that don't follow standards |
| Fictitious (fraudulent) | Fabricated transactions, numbers are made up |
Common Manipulation Techniques
Revenue Manipulation
- Channel stuffing: Shipping excess inventory to distributors to book revenue early
- Bill-and-hold: Recognizing revenue before goods are shipped
- Barter transactions: Inflating revenue through non-arm's-length exchanges
Expense Manipulation
- Capitalizing operating expenses: Moves expense from income statement to balance sheet
- Extending asset lives: Reduces annual depreciation, inflates income
- Understating bad debt reserves: Lower expense, higher income
- Big bath charges: Taking massive write-offs in a bad year to boost future earnings
Cash Flow Manipulation
- Stretching payables: Delays supplier payments to inflate CFO
- Capitalizing interest: Moves interest from CFO to CFI
Warning Signs
Revenue growing faster than peers, declining receivables turnover, decreasing asset turnover, growing gap between NI and CFO, frequent "nonrecurring" charges, related-party transactions, changes in accounting methods or estimates, qualified audit opinions, management turnover. One flag is curious; three is a pattern.
π― Likely Exam Question
An analyst notices that a company's revenue has been growing 15% annually while its accounts receivable have been growing 30% annually. This most likely indicates:
Answer: Aggressive revenue recognition or declining collection quality. If receivables grow faster than revenue, the company may be booking revenue it hasn't collected, offering extended terms to boost sales, or engaging in channel stuffing.
Reading 37
Financial Analysis Techniques
The ratio toolkit, DuPont decomposition, and common-size analysis.
The Four Ratio Categories
| Category | What It Measures | Key Ratios |
|---|---|---|
| Activity | Efficiency of asset use | Receivables turnover, inventory turnover, total asset turnover |
| Liquidity | Ability to pay short-term obligations | Current ratio, quick ratio, cash ratio, defensive interval |
| Solvency | Ability to meet long-term obligations | Debt-to-equity, debt-to-capital, interest coverage |
| Profitability | Ability to generate profits | Gross/net/operating margins, ROA, ROE, ROIC |
Key Activity Ratios
\[ \text{Receivables Turnover} = \frac{\text{Revenue}}{\text{Avg Receivables}} \qquad \text{DSO} = \frac{365}{\text{Receivables Turnover}} \]
\[ \text{Inventory Turnover} = \frac{\text{COGS}}{\text{Avg Inventory}} \qquad \text{DOH} = \frac{365}{\text{Inventory Turnover}} \]
\[ \text{Payables Turnover} = \frac{\text{Purchases}}{\text{Avg Payables}} \qquad \text{Days Payable} = \frac{365}{\text{Payables Turnover}} \]
\[ \text{Total Asset Turnover} = \frac{\text{Revenue}}{\text{Avg Total Assets}} \]
\[ \text{Cash Conversion Cycle} = \text{DSO} + \text{DOH} - \text{Days Payable} \]
The cash conversion cycle tells you how many days a company's cash is tied up in its operating cycle. A shorter cycle means faster cash generation. Negative cycles (like Amazon) mean the company collects from customers before paying suppliers β effectively using supplier cash to fund operations.
Key Liquidity Ratios
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]
\[ \text{Quick Ratio} = \frac{\text{Cash} + \text{Short-term Investments} + \text{Receivables}}{\text{Current Liabilities}} \]
\[ \text{Cash Ratio} = \frac{\text{Cash} + \text{Short-term Investments}}{\text{Current Liabilities}} \]
\[ \text{Defensive Interval} = \frac{\text{Cash} + \text{Short-term Investments} + \text{Receivables}}{\text{Daily Operating Expenditures}} \]
The defensive interval measures how many days a company can fund operations from liquid assets alone β without any new revenue. It is the most conservative liquidity measure.
Key Solvency Ratios
\[ \text{Debt-to-Equity} = \frac{\text{Total Debt}}{\text{Total Shareholders' Equity}} \]
\[ \text{Debt-to-Capital} = \frac{\text{Total Debt}}{\text{Total Debt} + \text{Total Equity}} \]
\[ \text{Debt-to-Assets} = \frac{\text{Total Debt}}{\text{Total Assets}} \]
\[ \text{Interest Coverage (EBIT-based)} = \frac{\text{EBIT}}{\text{Interest Expense}} \]
\[ \text{Fixed Charge Coverage} = \frac{\text{EBIT} + \text{Lease Payments}}{\text{Interest Expense} + \text{Lease Payments}} \]
Key Profitability Ratios
\[ \text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} = \frac{\text{Revenue} - \text{COGS}}{\text{Revenue}} \]
\[ \text{Operating Profit Margin} = \frac{\text{EBIT}}{\text{Revenue}} \]
\[ \text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}} \]
\[ \text{ROA} = \frac{\text{Net Income}}{\text{Avg Total Assets}} \]
\[ \text{ROE} = \frac{\text{Net Income}}{\text{Avg Shareholders' Equity}} \]
\[ \text{ROIC} = \frac{\text{NOPAT}}{\text{Invested Capital}} = \frac{\text{EBIT} \times (1 - \text{Tax Rate})}{\text{Debt} + \text{Equity}} \]
DuPont Analysis Critical
3-Part (Original) DuPont
\[ \text{ROE} = \underbrace{\frac{\text{Net Income}}{\text{Revenue}}}_{\text{Net Profit Margin}} \times \underbrace{\frac{\text{Revenue}}{\text{Avg Assets}}}_{\text{Asset Turnover}} \times \underbrace{\frac{\text{Avg Assets}}{\text{Avg Equity}}}_{\text{Financial Leverage}} \]
5-Part (Extended) DuPont
\[ \text{ROE} = \underbrace{\frac{\text{NI}}{\text{EBT}}}_{\text{Tax Burden}} \times \underbrace{\frac{\text{EBT}}{\text{EBIT}}}_{\text{Interest Burden}} \times \underbrace{\frac{\text{EBIT}}{\text{Revenue}}}_{\text{EBIT Margin}} \times \underbrace{\frac{\text{Revenue}}{\text{Avg Assets}}}_{\text{Turnover}} \times \underbrace{\frac{\text{Avg Assets}}{\text{Avg Equity}}}_{\text{Leverage}} \]
DuPont's power is DECOMPOSITION, not calculation. If ROE stays flat but margins are falling and leverage is rising, the company is masking operational weakness with debt β a red flag. The 5-part version shows whether ROE is being maintained by tax optimization or debt loading.
π― Likely Exam Question
A company's ROE remained at ~18% for three years. DuPont analysis shows net margin fell from 7.0% to 5.3%, asset turnover fell from 1.33 to 1.17, while leverage rose from 1.93 to 2.78. What should the analyst conclude?
Answer: The stable ROE is misleading. Both operational efficiency (margin) and asset utilization (turnover) have deteriorated. ROE is being propped up by significantly higher financial leverage, which increases risk. The analyst should be concerned about sustainability and rising default risk.
π― Likely Exam Question
Using the extended DuPont, more leverage does not always lead to higher ROE because:
Answer: As leverage rises, interest expense increases, which reduces the interest burden ratio (EBT/EBIT). The negative effect of higher interest payments can offset the positive effect of the leverage multiplier.
Reading 38
Introduction to Financial Statement Modeling
Building pro forma statements and understanding competitive forces.
Sales-Based Pro Forma Model β 8 Steps
| Step | What You Model | Method |
|---|---|---|
| 1 | Revenue growth | Market growth Γ market share, trend growth, or GDP-relative |
| 2 | COGS | % of sales, or detailed by cost component |
| 3 | SG&A | Fixed, growing with revenue, or mixed |
| 4 | Financing costs | Interest rates Γ debt levels |
| 5 | Tax expense | Historical effective rates, segment analysis |
| 6 | Balance sheet | Working capital items flow from income statement |
| 7 | PP&E | CapEx for maintenance + growth, net of depreciation |
| 8 | Cash flow statement | Built from completed IS and BS |
Porter's Five Forces β Impact on Financials
| Force | Pricing Power When⦠| Financial Impact |
|---|---|---|
| Threat of substitutes | Low substitutes, high switching costs | Higher margins, sustainable revenue |
| Industry rivalry | Low rivalry (concentrated industry) | Less price competition |
| Supplier power | Many suppliers, low supplier concentration | Lower input costs |
| Buyer power | Fragmented customer base | Less price pressure from customers |
| Threat of new entrants | High barriers to entry | Sustainable economic profits |
Behavioral biases matter for analysts too. Confirmation bias makes analysts seek data that supports their existing view. Overconfidence leads to forecast ranges that are too narrow. Anchoring causes analysts to under-adjust from initial estimates. Always seek disconfirming evidence.
Reference
Master Formula Sheet β All 12 Readings
Every formula you need, in one place.
| Formula | Description | Reading |
|---|---|---|
| \(\text{Basic EPS} = \frac{\text{NI} - \text{Pref Div}}{\text{WACS}}\) | Basic earnings per share | 28 |
| \(\text{Diluted EPS: Treasury Stock Method}\) | Net new shares = options β (proceeds / avg price) | 28 |
| \(\text{Current Ratio} = \frac{\text{CA}}{\text{CL}}\) | Liquidity measure | 29 |
| \(\text{Quick Ratio} = \frac{\text{Cash + MS + AR}}{\text{CL}}\) | Stringent liquidity | 29 |
| \(\text{Goodwill} = \text{Price} - \text{FV Net Assets}\) | Excess purchase price in acquisitions | 29 |
| \(\text{CFO} = \text{NI} + \text{NCC} - \text{WCInv}\) | Indirect method CFO | 30 |
| \(\text{FCFF} = \text{CFO} + \text{Int}(1-t) - \text{FCInv}\) | Free cash flow to the firm | 31 |
| \(\text{FCFE} = \text{CFO} - \text{FCInv} + \text{Net Borrowing}\) | Free cash flow to equity | 31 |
| \(\text{Inventory Turnover} = \frac{\text{COGS}}{\text{Avg Inv}}\) | Efficiency of inventory management | 32 |
| \(\text{CCC} = \text{DSO} + \text{DOH} - \text{Payables Period}\) | Cash conversion cycle | 37 |
| \(\text{Average Age} = \frac{\text{Accum Depr}}{\text{Annual Depr}}\) | Estimate asset age from disclosures | 33 |
| \(\text{Remaining Life} = \frac{\text{Net PP\&E}}{\text{Annual Depr}}\) | Estimate remaining asset life | 33 |
| \(\text{Tax Exp} = \text{Tax Payable} + \Delta\text{DTL} - \Delta\text{DTA}\) | Income tax expense decomposition | 35 |
| \(\text{Effective Tax Rate} = \frac{\text{Tax Expense}}{\text{Pretax Income}}\) | Actual tax burden | 35 |
| \(\text{ROE} = \text{Margin} \times \text{Turnover} \times \text{Leverage}\) | 3-part DuPont decomposition | 37 |
| \(\text{ROE} = \frac{\text{NI}}{\text{EBT}} \times \frac{\text{EBT}}{\text{EBIT}} \times \frac{\text{EBIT}}{\text{Rev}} \times \frac{\text{Rev}}{\text{Assets}} \times \frac{\text{Assets}}{\text{Equity}}\) | 5-part Extended DuPont | 37 |
| \(\text{Debt-to-Equity} = \frac{\text{Total Debt}}{\text{Total Equity}}\) | Solvency ratio | 37 |
| \(\text{Interest Coverage} = \frac{\text{EBIT}}{\text{Interest Expense}}\) | Ability to cover interest | 37 |
| \(\text{ROA} = \frac{\text{Net Income}}{\text{Avg Total Assets}}\) | Return on assets | 37 |
| \(\text{Gross Margin} = \frac{\text{Rev} - \text{COGS}}{\text{Rev}}\) | Profitability before operating expenses | 28 |