Overview
Financial Statement Analysis (FSA) is one of the two highest-weighted topics on the Level I exam (alongside Ethics). Candidates must understand how the three core financial statements are constructed, how they interrelate, and how to use ratios to assess profitability, liquidity, solvency, and efficiency. Questions also test knowledge of accounting choices that affect reported numbers.
The Income Statement
The income statement reports revenues, expenses, and net income over a period. Key metrics include gross profit (revenue minus COGS), operating income (EBIT), and net income. Analysts adjust reported earnings for non-recurring items to estimate sustainable operating performance.
Revenue recognition under IFRS 15 / ASC 606 follows a five-step model: identify the contract, identify performance obligations, determine the transaction price, allocate it to obligations, and recognize revenue when (or as) obligations are satisfied. Aggressive revenue recognition — recording revenue early or fabricating it — is a common earnings quality red flag.
The Balance Sheet
The balance sheet presents assets, liabilities, and equity at a point in time. The fundamental equation: Assets = Liabilities + Equity. Current assets (cash, receivables, inventory) support operations in the short run; non-current assets (PP&E, intangibles, goodwill) generate long-run value.
Key accounting judgments on the balance sheet include: inventory costing methods (FIFO vs. LIFO vs. weighted average), depreciation methods (straight-line vs. accelerated), and impairment testing for intangibles and goodwill.
The Cash Flow Statement
The cash flow statement classifies cash movements into operating (CFO), investing (CFI), and financing (CFF) activities. CFO is the most important section for assessing earnings quality: if net income consistently exceeds CFO, accruals may be inflating profits.
The indirect method starts with net income and adjusts for non-cash items and working capital changes. The direct method reports actual cash receipts and payments. Analysts prefer free cash flow to the firm (FCFF = CFO + after-tax interest − capex) as a measure of value-generating capacity.
Financial Ratios
Ratios are analyzed in context — relative to industry benchmarks, historical trends, and peer companies.
- Profitability: ROE, ROA, gross margin, net margin, operating margin
- Liquidity: Current ratio, quick ratio, cash ratio
- Solvency: Debt-to-equity, interest coverage (EBIT/interest), debt-to-assets
- Efficiency (activity): Receivables turnover, days sales outstanding, inventory turnover, asset turnover
DuPont decomposition breaks ROE into: Net margin × Asset turnover × Equity multiplier — separating profitability, efficiency, and leverage effects.
Quality of Earnings
High-quality earnings are sustainable, backed by cash flows, and free from aggressive accounting. Warning signs include rapid revenue growth without matching cash flows, large accruals relative to assets, frequent changes in accounting estimates, and related-party transactions. The Beneish M-score and Altman Z-score are quantitative tools for detecting manipulation and distress.