FSA Notes Summary & Study Notes

What this is about 📘

• Financial statement analysis teaches how to read, interpret, and evaluate the economic story in a company's financial reports.
• It breaks financial reports into basic building blocks (income, assets, liabilities, cash flows) and shows how to use ratios and adjustments to compare firms and detect issues.
• These notes walk from the simplest building blocks to key analysis techniques a beginner needs.

Atomic building blocks — the reports & their purpose 🧱

• Companies publish three primary reports to show performance and position:

  • Income statement → shows profitability over a period.
  • Balance sheet → shows financial position at a point in time.
  • Statement of cash flows → shows actual cash movements over a period.

• Each report has limitations and needs context (notes, management commentary, auditor report).

• After understanding what each report does, analysts adjust and combine them to assess value and risk.

• The key terms to memorize after reading this section: income statement, balance sheet, statement of cash flows.

Introduction: Roles of financial reporting & analysis 🔍

• Purpose of financial reporting: provide information useful for economic decisions by investors, creditors, and other users.
• Analysts use reports to: estimate future cash flows, assess risk, evaluate management decisions, and compare companies.
• Supporting materials: notes to accounts, management commentary, auditor's report, and other disclosures are critical for correct interpretation.

How the income statement works — basics & building blocks 📈

• Basic idea: measure revenues earned and expenses incurred during a period to arrive at profit.
• Key components (smallest pieces):
  • Revenue (sales): inflows from delivering goods/services.
  • Cost of goods sold (COGS): direct cost to produce goods sold.
  • Gross profit = Revenue − COGS.
  • Operating expenses: selling, general & admin, R&D.
  • Operating profit (EBIT) = Gross profit − Operating expenses.
  • Non-operating items: interest, gains/losses, taxes.
  • Net income = All revenues − All expenses (bottom-line profit).
• Timing: income statement covers a period (e.g., quarter, year).

Important income-statement concepts

• Accrual accounting: record revenues when earned and expenses when incurred, not necessarily when cash changes hands.

  • Use to match costs with the revenues they generate.

• Expense recognition principle: expenses are recognized when they contribute to revenue, or when incurred if matching not possible.

• Non-recurring items: gains/losses unlikely to happen again (e.g., asset sale); analysts often separate these to see recurring earnings.

• Earnings per share (EPS): net income available to common shareholders divided by weighted average shares outstanding.

  • Formula: $EPS = \frac{Net\;Income - Preferred\;Dividends}{Weighted\;Average\;Shares}$
  • Explain symbols: Net Income = company profit; Preferred Dividends = dividends required by preferred shares.

• Common-size income statement: express each line as a percentage of revenue to compare across companies and time.

• Key ratios from the income statement: gross margin, operating margin, net margin.

• After explaining, memorize: accrual accounting, EPS.

Balance sheet basics — what it shows 🧾

• Purpose: snapshot of resources (assets), obligations (liabilities), and owners' claim (equity) at a point in time.
• Fundamental identity: Assets = Liabilities + Equity (this always balances).
• Break the pieces:
  • Assets: current (convertible to cash within 12 months) and noncurrent (longer-lived).
  • Liabilities: current (due within 12 months) and long-term.
  • Shareholders’ equity: contributed capital, retained earnings, other reserves.
• Uses: assess liquidity (short-term ability to pay), solvency (long-term ability to meet obligations), and capital structure.
• Limitations: many items measured at historical cost, estimates and judgments (e.g., useful lives, impairments) affect numbers.

Balance-sheet detail

• Current vs noncurrent classification affects liquidity ratios.

• Common-size balance sheet: express each line as percentage of total assets to compare firms/periods.

• Important ratios: current ratio ($\frac{Current\;Assets}{Current\;Liabilities}$), quick ratio, debt-to-equity.

• Key terms to memorize: assets, liabilities, equity.

Statement of cash flows — why cash is different 💵

• Purpose: show cash inflows and outflows during the period, grouped by activity type.
• Three sections:
  1. Cash flows from operating activities (CFO) — cash from core operations.
  2. Cash flows from investing activities (CFI) — cash used for/received from buying or selling long-term assets.
  3. Cash flows from financing activities (CFF) — cash from issuing debt/equity or paying dividends/repaying debt.
• Cash ≠ profit; accrual accounting makes net income different from CFO.
• Direct vs indirect method for CFO:
  • Direct: shows actual cash receipts and payments.
  • Indirect: starts with net income and adjusts for non-cash items and working-capital changes.
• Relationship with IS & BS: CFO reconciles net income to cash by adding back non-cash expenses (depreciation) and adjusting working capital changes.

Practical cash-flow ideas

• Free cash flow (FCF): cash available after necessary investments. Common measures:

  • $FCF = CFO - Capital\;Expenditures$ (simple form).

• Cash-flow ratios: operating cash flow margin ($\frac{CFO}{Sales}$), cash conversion cycle analysis (linking inventory, receivables, payables).

• Key terms: CFO, free cash flow.

Inventory analysis — why valuation and flow assumptions matter 📦

• Inventory is a current asset that becomes expense (COGS) when sold.

• Cost behavior: inventory costs move between balance sheet (asset) and income statement (expense) as goods are sold.

• Valuation methods: FIFO, LIFO, Weighted Average, Specific Identification — different methods change COGS and inventory values.

• Perpetual vs periodic inventory systems:

  • Perpetual updates inventory continuously.
  • Periodic updates at period-end.

• Inflation/deflation effects: under inflation, FIFO reports higher profit and higher ending inventory than LIFO; reverse under deflation.

• LIFO reserve: difference between FIFO and LIFO inventory — useful to adjust comparability.

• Inventory metrics: inventory turnover ($\frac{COGS}{Average\;Inventory}$), days inventory outstanding.

• Memorize: FIFO, LIFO reserve.

Long-term assets — capitalization, depreciation, impairments 🏗️

• Expense vs capitalize: decide whether a cost is recognized immediately (expense) or recorded as an asset and expensed over time (capitalized).
• Depreciation (tangible) and amortization (intangible) allocate capitalized cost over useful life.
• Depreciation methods (examples): straight-line, declining-balance, units-of-production. Method changes timing of expense, affecting profit and book value.
• Revaluation model (IFRS option): assets may be revalued to fair value; GAAP generally uses historical cost.
• Impairment: when carrying amount exceeds recoverable amount, write down asset to recoverable amount; affects income statement and balance sheet.
• Disposals/derecognition: removing assets when sold or retired — recognize gain or loss.

Analyst focus for long-term assets

• Check capitalization policies (what costs are capitalized), useful-life assumptions, and impairment frequency.

• Compute useful checks: implied depreciation rate, capital expenditures vs depreciation, changes in gross vs net PPE.

• Key terms: capitalization, impairment.

Long-term liabilities & equity topics — debt, leases, pensions, and capital structure ⚖️

• Debt recognition: bonds and loans recognized at present value of future payments; interest expense recognizes cost of borrowing.

• Derecognition: when debt is repaid or extinguished; gains/losses may result.

• Debt covenants: contractual terms that may restrict company behavior — breach can cause reclassification or default risk.

• Leases: treatment depends on lease classification (IFRS/US GAAP similarity now) — right-of-use asset and lease liability recognized for lessees.

• Pension plans: defined contribution vs defined benefit — different recognition of obligations and expense.

• Equity components: common stock, preferred stock, retained earnings, treasury stock, other comprehensive income items.

• Leverage ratios: debt-to-equity, debt-to-assets — measure capital structure and financial risk.

• Memorize: debt covenants, defined benefit.

Income taxes — current vs deferred and why temporary differences matter 🧾➡️💰

• Accounting profit ≠ taxable income due to timing and permanent differences.

• Temporary differences create deferred tax assets (DTA) or deferred tax liabilities (DTL) depending on whether taxes are payable in future.

• Valuation allowance: reduce DTA if it’s more likely than not that some will not be realized.

• Tax-rate changes affect measurement of deferred tax balances.

• Disclose current and deferred tax components in notes.

• Key terms: deferred tax asset, valuation allowance.

Financial reporting quality — detecting aggressive vs conservative accounting ⚠️

• Quality concept: degree to which reported financials faithfully represent economic reality and are useful for decision-making.

• Low-quality signals: frequent one-off items, aggressive revenue recognition, big changes in reserves, poor disclosure, related-party transactions.

• Mechanisms that discipline reporting: auditors, regulators, market forces, debt covenants, compensation structures.

• Presentation choices and accounting policy choices (e.g., FIFO vs LIFO, useful lives) can be used to manage reported results.

• Memorize: reporting quality, aggressive accounting.

Financial analysis techniques — ratios, trends, and decomposition 🔬

• Analytical tools: common-size statements, trend analysis (time series), ratio analysis, benchmarking vs peers, and DuPont decomposition.

• Key ratio categories: liquidity, activity/efficiency, leverage, profitability, market valuation.

• DuPont analysis decomposes ROE into components to show drivers of return:

  • Classic decomposition: $ROE = Net\;Profit\;Margin \times Asset\;Turnover \times Equity\;Multiplier$
  • Explain symbols: Net Profit Margin = $\frac{Net\;Income}{Sales}$; Asset Turnover = $\frac{Sales}{Assets}$; Equity Multiplier = $\frac{Assets}{Equity}$.

• Industry-specific ratios: inventory turnover in retail, loan-to-deposit in banking, load factors in airlines — choose ratios appropriate to the business model.

• Key terms: DuPont analysis, asset turnover.

Putting it together: financial statement modeling basics 🧩

• Modeling idea: use historical financials to forecast future income, balance sheet, and cash flows and value a company.
• Modeling steps (sequential):
  1. Input historical financial statements and key assumptions.
  2. Forecast income statement (sales growth, margins).
  3. Forecast balance-sheet drivers (working capital ratios, capex, debt policy).
  4. Forecast cash flows (CFO, CFI, CFF) and compute FCF.
  5. Value using discounted cash flow or relative multiples.
• Use ratio analysis in modeling to make assumptions consistent and comparable.

Notes, disclosures, and auditor reports — why they matter 📝

• Notes explain accounting policies, unusual items, contingencies, related-party transactions, and segment results.

• Auditor's report gives opinion on whether statements present fairly — check for modified opinions or emphasis of matter.

• Management commentary (MD&A) provides context, strategy, and management’s view of performance and risks.

• Memorize: notes to accounts, auditor's report.

Quick reference: common formulas & what they tell you 🧾

• Current ratio = $\frac{Current\;Assets}{Current\;Liabilities}$ → liquidity.
• Quick ratio = $\frac{Current\;Assets - Inventory}{Current\;Liabilities}$ → stricter liquidity.
• Inventory turnover = $\frac{COGS}{Average\;Inventory}$ → inventory efficiency.
• Return on equity (ROE) = $\frac{Net\;Income}{Average\;Equity}$ → shareholder return.
• Debt-to-equity = $\frac{Total\;Debt}{Total\;Equity}$ → leverage.
• Explain each symbol when used (COGS = cost of goods sold; Average Inventory = average of opening and closing inventories, etc.).

How to study and apply these notes — practical tips 🛠️

• Read all three statements together for a period (IS, BS, CF) to see how items move between them.
• Recreate cash-flow statement from net income and balance-sheet changes to practice reconciliation.
• Convert income and balance sheet to common-size percentages and compare peers.
• Look for red flags: big one-off items, frequent accounting-policy changes, mismatches between CFO and net income.
• Use DuPont to diagnose whether ROE changes come from margins, efficiency, or leverage.

If you want, I can:

• Expand any section into worked examples (e.g., convert indirect to direct CFO, compute DuPont with numbers).
• Create a one-page cheat sheet of formulas and common adjustments.