By Stella Goh – Market Data Analyst | 24 July 2019
In my previous Article of “CFA Level I Financial Reporting and Analysis (Part I)”, I hope you had understood Reading 21 and Reading 22. Today, I would like to continue to discuss on what content we can learn from Reading 23 to Reading 26.
Reading 23 Understanding Income Statements
In this reading, candidates can have a better understanding of the income statement together with the comprehensive income. The income statement is a statement which is also known as Profit & Loss (P&L) statements, Statements of Earnings, and Statements of Operations. The income statements display a company’s revenue, cost incurred, gross profit, selling and administrative expenses, other expenses and income, taxes paid and net profit. The basic equation which underlying the income statements are as follow:-
Total Revenue – Total Expenses = Net Income
Besides, in this reading candidate are also able to learn on the general principles of revenue recognition, accrual accounting, specific revenue recognition applications, the implication of revenue recognition, principles of expenses recognition, specific expenses recognition applications, and impact of expense recognition. Candidates can differentiate between income statement presented by International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP). Moreover, the differences between operating components versus non-operating components of income statements, dilutive securities versus anti-dilutive securities, changes in accounting policies, analysis of non-recurring items and the explanation about financial reporting treatment also will be discussed in this reading together with some examples provided.
Reading 24 Understanding Balance Sheets
In this reading, candidates can have a better understanding of balance sheets. A balance sheet is a financial statement of a company that used to report on the company’s assets, liabilities and shareholder’s equity. A balance sheet can be used to assist investors in computing the rates of returns and evaluating the company’s capital structure. Assets in the balance sheet can be classified into either short-term or long-term assets. The short-term assets such as cash, marketable securities, and accounts receivables will be consumed within one year. Whereas the long-term assets such as lands, buildings, office types of equipment, furniture, fixtures and fittings, will be consumed more than one year. While for liabilities, it can also be categorised into either current liabilities or non-current liabilities in the balance sheet. A liability is an obligation or legal financial debts that arise during business operations.
For balance sheet to reflect on the true picture, the assets are always equal to the liabilities plus equities. The formula is as follow:-
Assets = Liabilities + Equity
Besides elements of balance sheets, candidates are also able to learn on:
- How to interpret and convert the balance sheets into the standard size of balance sheets,
- How to determine the use and limitation of a balance sheet, alternative formats of balance sheet presentation, components of shareholder’s equity,
- How to calculate and interpret the solvency and liquidity ratios in this reading, together with some examples provided.
Reading 25 Understanding Cash Flow Statements
In reading 25, candidates are also able to have a better understanding of how the cash flow activities are reflected in the company’s cash flow statement. Cash flow statements are used to measure how the companies use it to manage their cash position.
Besides, candidates are also able to learn how to differentiate the three primary areas, such as operating activities, investment activities, and financing activities. Operating activities such as account receivables, account payables, inventory costs, depreciation, etc are used to measure how much cash is generated by a company’s products or services and how much money is being spent to produce or deliver products and services. For investing activities, it highlights the changes in cash outflow, which results from capital expenditures such as new property, business vehicles, or equipment, etc. While for financing activities such as the issuance of stocks, dividend payment, and so on, it records the changes in the cash flow, which are regarding the companies to raise capital for their business.
Moreover, candidates are to learn:
- To differentiate between the direct and indirect methods from the operating activities
- How to convert cash flow from indirect methods to direct practices, know the steps to prepare direct and indirect cash flow statements,
- How non-cash investing and financing activities are reported,
- How the cash flow statement linked to the income statement and balance sheet statement, cash-based information versus accrual-based information from an income statement
- How to contrast the cash flow statements prepared under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP).
Reading 26 Financial Analysis Techniques
A financial analysis tool is essential, which can be used to assess a company’s performance and trends. The primary sources of data they use for analysis will be the company’s annual reports, financial statements, notes, and management commentary. In this reading, candidates can learn more about the different ways of data presented in the financial reports prepared under the International Financial Reporting Standard (IFRS) and United Generally Accounting Principles (US GAAP). An analyst typically needs to supplement the information found in the financial reports with other details such as information on the economy, industry, comparable companies and the company itself.
Besides, candidates are to learn tools and techniques for financial analysis, interpret the relationship between ratios, a requirement of segment reporting.
Also, on how the ratio analysis with other methods can be used to model and forecast the earnings in this reading. Last but not least, the application of DuPont Analysis, Return on Equity, and Credit Analysis, also will be discussed in this reading, together with some examples provided.
Conclusion
In conclusion, candidates can understand very well on the three major of financial statements such as income statement, balance sheet and cash flow statement. Essential things in these readings are the purpose, elements, construction, pertinent ratios, and standard size analysis are presented for each of the significant financial statements. At the end of these reading, it concludes with a discussion on financial analysis technique, which includes the use of ratios to evaluate the corporate financial health.