Skip to content

Get the app

Study guide · Session 1

Financial Statement Analysis

11-14% of the exam · session 1 · 12 learning modules

Financial Statement Analysis covers how companies report revenue, expenses, assets, liabilities, cash flows and taxes under IFRS and US GAAP, and how an analyst adjusts and interprets those numbers. Level I questions mix short calculations (EPS, cash flows, inventory, deferred tax, ratios) with recognition rules and the effect of a reporting choice on the statements and ratios.

A study feature written by ExamDragon, not part of the real exam. Each heading is one of this topic's 12 learning modules in the 2027 curriculum, named in our own words.

At a glance

Session 1
11-14%

of the exam, as CFA Institute weights it for 2027

Weight
11-14%
Modules
12
Key terms
10

What this guide covers, module by module

  1. FSA.1The analyst's framework and information sources
  2. FSA.2Revenue, expenses and earnings per share
  3. FSA.3Reading the balance sheet
  4. FSA.4Building the cash flow statement
  5. FSA.5Interpreting cash flows and free cash flow
  6. FSA.6Inventory measurement and cost flows
  7. FSA.7Intangibles, impairment and asset disposals
  8. FSA.8Leases, pensions and share-based pay
  9. FSA.9Deferred taxes and tax rates
  10. FSA.10Judging the quality of reported numbers
  11. FSA.11Ratios, DuPont and comparative analysis
  12. FSA.12Forecasting with pro forma models

FSA.1The analyst's framework and information sources

  • The analysis framework has six steps: set the purpose and context, collect data, process data, analyse and interpret, develop and communicate conclusions, follow up.
  • Analysis serves decisions: lending, investing, valuing a company, assessing management or a counterparty.
  • The core sources are the financial statements with their notes, management's commentary and the auditor's report; the notes hold accounting policies, estimates and detail behind the totals.
  • Audit opinions: unqualified (clean), qualified (an 'except for' matter), adverse (not fairly presented), or a disclaimer (no opinion possible); key audit matters flag areas of significant judgement.
  • Standard setters (IASB, FASB) write the rules; securities regulators recognise and enforce them for listed companies.
  • Beyond annual and interim reports, analysts use earnings calls, regulatory filings, industry data, economic statistics and company presentations.
  1. The situationA bank is asked to extend a three-year loan to a mid-sized manufacturer.
  2. Step 1Purpose: can the borrower service and repay the loan over three years?
  3. Step 2Collect: five years of statements, the notes, the audit report, the debt agreements and industry data.
  4. Step 3Process and analyse: common-size statements, coverage and leverage ratios, cash flow trends.
  5. Step 4Conclude and report: a recommendation with the covenant levels to monitor.
  6. Where questions turnManagement's commentary is generally not audited; only the financial statements and notes carry the audit opinion.
  7. The takeawayThe purpose set at the start decides which data and ratios matter most.
Practise FSA.1

FSA.2Revenue, expenses and earnings per share

  • IFRS 15 and ASC 606 use five steps: identify the contract, identify the performance obligations, set the price, allocate it, recognise revenue when or as each obligation is satisfied.
  • Expenses are matched to the revenue they help earn or to the period; a cost with future benefit is capitalised and expensed later through depreciation or amortisation.
  • Discontinued operations are shown separately, net of tax; unusual or infrequent items stay in continuing operations but may be disclosed.
  • Basic EPS = (net income - preferred dividends) / weighted average ordinary shares; stock splits and stock dividends are applied retroactively.
  • Diluted EPS adds potential shares: convertibles by the if-converted method (add back the preferred dividend or after-tax interest), options by the treasury stock method.
  • A security is antidilutive, and left out, if including it would raise EPS.
  • Common-size income statements show each line as a percentage of revenue, for gross, operating and net margins.
  1. The situationNet income EUR 9,000,000, preferred dividends EUR 1,000,000, 4,000,000 shares all year and 800,000 shares issued on 1 July.
  2. Step 1Earnings to ordinary shareholders = 9,000,000 - 1,000,000 = 8,000,000.
  3. Step 2Weighted shares = 4,000,000 + 800,000 x 6/12 = 4,400,000.
  4. Step 3Basic EPS = 8,000,000 / 4,400,000 = EUR 1.82.
  5. Where questions turnDiluted EPS can never be above basic EPS; a security that would raise it is antidilutive and excluded.
  6. The takeawayNew shares count only for the part of the year they are outstanding.
Practise FSA.2

FSA.3Reading the balance sheet

  • Purchased intangibles are recorded at cost; internally generated ones are mostly expensed; in an acquisition, identifiable intangibles are recorded at fair value.
  • Goodwill = purchase price - fair value of identifiable net assets; it is not amortised under IFRS, is tested for impairment at least annually, and an impairment is never reversed.
  • IFRS 9 classifies financial assets at amortised cost, fair value through OCI or fair value through profit or loss, by business model and cash flow characteristics.
  • Non-current liabilities include bonds (at amortised cost using the effective interest rate), lease liabilities, provisions and deferred tax liabilities.
  • Common-size balance sheets show each item as a percentage of total assets.
  • Liquidity: current ratio = current assets / current liabilities; quick ratio = (cash + marketable securities + receivables) / current liabilities; cash ratio uses cash and marketable securities only.
  • Solvency: debt-to-assets, debt-to-capital, debt-to-equity and the financial leverage ratio (assets / equity).
  1. The situationCurrent assets 600 (cash 100, receivables 200, inventory 300), current liabilities 400, debt 500, equity 1,000.
  2. Step 1Current ratio = 600 / 400 = 1.5.
  3. Step 2Quick ratio = (100 + 200) / 400 = 0.75.
  4. Step 3Debt-to-equity = 500 / 1,000 = 0.5; debt-to-capital = 500 / 1,500 = 0.33.
  5. Where questions turnDebt in solvency ratios means interest-bearing obligations, not all liabilities.
  6. The takeawayA comfortable current ratio can hide weak liquidity when inventory is a large share of current assets.
Practise FSA.3

FSA.4Building the cash flow statement

  • Cash flows are split into operating, investing and financing activities; the net change reconciles opening and closing cash on the balance sheet.
  • Indirect method: start from net income, add back non-cash charges such as depreciation, remove gains and add losses on disposals, then adjust for working capital.
  • An increase in an operating asset (receivables, inventory) uses cash; an increase in an operating liability (payables, accruals) provides cash.
  • Direct method lines: cash from customers = revenue - increase in receivables + increase in unearned revenue; cash to suppliers = cost of sales + increase in inventory - increase in payables.
  • IFRS allows interest and dividends received in operating or investing, interest paid and dividends paid in operating or financing; US GAAP puts interest received and paid and dividends received in operating, dividends paid in financing.
  • Taxes paid are operating under both, unless IFRS links them to investing or financing items.
  1. The situationNet income 200, depreciation 50, receivables up 30, payables up 10.
  2. Step 1Start with net income: 200.
  3. Step 2Add back depreciation: 200 + 50 = 250.
  4. Step 3Working capital: -30 for receivables, +10 for payables, giving 230.
  5. Where questions turnSigns on working capital changes are the common error: a rise in an asset is a deduction, a rise in a liability an addition.
  6. The takeawayOperating cash flow of 230 exceeds net income because of the depreciation add-back, partly offset by cash tied up in receivables.
Practise FSA.4

FSA.5Interpreting cash flows and free cash flow

  • Read the cash flow statement for the main sources and uses of cash, and whether operations fund investment and dividends over time.
  • Common-size cash flows show each item as a percentage of revenue or of total inflows.
  • FCFF = CFO + interest paid x (1 - t) - fixed capital investment (when interest paid is in CFO).
  • FCFE = CFO - fixed capital investment + net borrowing.
  • Performance ratios: cash flow to revenue, cash return on assets, cash to income (CFO / operating income).
  • Coverage ratios: debt coverage (CFO / total debt), interest coverage ((CFO + interest paid + taxes paid) / interest paid), reinvestment (CFO / capital expenditure).
  1. The situationCFO 400 (interest paid of 40 included), tax rate 25%, capital expenditure 150, net borrowing 20.
  2. Step 1FCFF = 400 + 40 x 0.75 - 150 = 280.
  3. Step 2FCFE = 400 - 150 + 20 = 270.
  4. Where questions turnInterest is added back to FCFF after tax, not in full.
  5. The takeawayFCFF is cash for all capital providers; FCFE is what remains for shareholders after debt flows.
Practise FSA.5

FSA.6Inventory measurement and cost flows

  • IFRS measures inventory at the lower of cost and net realisable value; write-downs are reversed if value recovers, but never above cost.
  • US GAAP uses lower of cost and net realisable value for FIFO and weighted average, and lower of cost or market for LIFO; reversals are not allowed.
  • IFRS permits specific identification, FIFO and weighted average cost; LIFO is allowed only under US GAAP.
  • With rising costs: FIFO gives lower cost of sales, higher profit and higher ending inventory; LIFO the reverse; weighted average sits between.
  • LIFO reserve = FIFO inventory - LIFO inventory; FIFO cost of sales = LIFO cost of sales - increase in the LIFO reserve.
  • Watch disclosures for write-downs, the mix of raw materials, work in progress and finished goods, and inventory growing faster than sales.
  1. The situationBuy 100 units at EUR 8, then 100 at EUR 10; sell 150.
  2. Step 1FIFO cost of sales = 100 x 8 + 50 x 10 = 1,300; ending inventory 500.
  3. Step 2Weighted average cost = 1,800 / 200 = 9; cost of sales = 150 x 9 = 1,350; ending inventory 450.
  4. Where questions turnUnder IFRS a write-down can be reversed, but only up to the original cost.
  5. The takeawayWith rising costs FIFO reports the lower cost of sales and the higher inventory.
Practise FSA.6

FSA.7Intangibles, impairment and asset disposals

  • Purchased intangibles are recorded at cost; internally developed ones are expensed except IFRS development costs that meet the criteria; in a business combination identifiable intangibles are recorded at fair value.
  • IFRS impairment: compare carrying amount with recoverable amount, the higher of fair value less costs of disposal and value in use; reversals are allowed except for goodwill.
  • US GAAP impairment for assets held for use: a recoverability test on undiscounted cash flows, then a loss measured to fair value; no reversals.
  • IFRS allows the revaluation model for PP&E: increases go to OCI (revaluation surplus) unless reversing a prior loss.
  • On derecognition, gain or loss = proceeds - carrying amount; the cash received is an investing inflow.
  • Disclosures give gross cost, accumulated depreciation and useful lives; accumulated depreciation / gross PP&E suggests average age.
  1. The situationUnder IFRS, a plant has a carrying amount of 500, fair value less costs of disposal 380 and value in use 420.
  2. Step 1Recoverable amount = higher of 380 and 420 = 420.
  3. Step 2Impairment loss = 500 - 420 = 80, charged to profit or loss.
  4. Where questions turnRecoverable amount is the higher of the two measures, not the lower.
  5. The takeawayAn impairment lowers assets and equity now and future depreciation later.
Practise FSA.7

FSA.8Leases, pensions and share-based pay

  • IFRS 16 lessees recognise a right-of-use asset and a lease liability for almost all leases, then depreciation and interest; short-term and low-value leases may be exempt.
  • US GAAP lessees also recognise both, but classify leases as finance (like IFRS 16) or operating (one straight-line lease cost).
  • Lessors classify leases as finance (derecognise the asset, record a receivable) or operating (keep the asset, record lease income).
  • Defined contribution plans: the expense is the contribution and the employee bears investment risk; defined benefit plans: the employer bears the risk and reports the net funded status.
  • Share-based pay is measured at grant-date fair value and expensed over the vesting period.
  • Disclosures give lease maturities, pension assumptions (discount rate, salary growth) and option valuation inputs.
  1. The situationA lessee pays EUR 5,000 at the end of each of 3 years; the rate is 5%.
  2. Step 1Lease liability = 5,000 x (1 - 1.05^-3) / 0.05 = 13,616.
  3. Step 2Year-1 interest = 13,616 x 5% = 681; depreciation = 13,616 / 3 = 4,539.
  4. Step 3Year-1 expense = 681 + 4,539 = 5,220, above the 5,000 cash payment.
  5. Where questions turnUnder IFRS 16 the principal part of each payment is a financing outflow, which raises operating cash flow relative to a US GAAP operating lease.
  6. The takeawayIFRS 16 expense is front-loaded, and only the interest part can sit in operating cash flow.
Practise FSA.8

FSA.9Deferred taxes and tax rates

  • Accounting profit is before tax under the reporting standards; taxable income is under tax rules; taxes payable are the tax on taxable income; income tax expense = taxes payable + change in DTL - change in DTA.
  • Temporary differences reverse; permanent differences do not and only change the effective tax rate.
  • A DTL arises when an asset's carrying amount exceeds its tax base (for example faster tax depreciation); a DTA when a liability's carrying amount exceeds its tax base (for example warranty provisions) or from tax losses.
  • A DTA is recognised only if future taxable profit is probable (IFRS) or reduced by a valuation allowance (US GAAP).
  • Effective tax rate = income tax expense / pre-tax profit; cash tax rate = taxes paid / pre-tax profit; the statutory rate is the legal rate.
  • The tax rate reconciliation walks from the statutory rate to the effective rate (foreign rates, tax-exempt income, non-deductible expenses, tax rate changes, valuation allowance changes); analysts separate recurring items from one-off ones to forecast the rate, and note that a change in the tax rate remeasures deferred tax balances through tax expense.
  • Analysts may treat a DTL that is not expected to reverse as equity rather than debt.
  1. The situationAn asset costs 300,000; accounting depreciation 100,000 a year, tax depreciation 150,000 in year 1; tax rate 30%.
  2. Step 1Carrying amount = 200,000; tax base = 150,000.
  3. Step 2Temporary difference = 50,000; DTL = 50,000 x 30% = 15,000.
  4. Where questions turnApply the tax rate to the temporary difference, not to a year's depreciation charge.
  5. The takeawayFaster tax depreciation defers tax, creating a liability that reverses later in the asset's life.
Practise FSA.9

FSA.10Judging the quality of reported numbers

  • Reporting quality is about whether the statements are useful and faithful; earnings quality is about whether results are sustainable and adequate.
  • The spectrum runs from compliant, decision-useful and sustainable at the top, through biased choices and managed earnings, to non-compliant and finally fraudulent reporting.
  • Aggressive accounting raises current results (early revenue, long useful lives); conservative accounting lowers them; both are biased.
  • Fraud needs motivation (targets, pay, covenants), opportunity (weak controls) and rationalisation.
  • Discipline comes from markets, regulators, auditors, boards and covenants, each with limits.
  • Warning signs: profit outrunning operating cash flow, receivables or inventory outrunning sales, frequent non-recurring charges, heavy use of non-GAAP measures.
  1. The situationRevenue grows 10% while receivables grow 35% and operating cash flow falls.
  2. Step 1Days of sales outstanding are rising, so customers are paying more slowly or sales are recognised early.
  3. Step 2Compare with peers and read the revenue policy note for changes.
  4. Step 3Treat reported growth as lower quality until cash catches up.
  5. Where questions turnConservative accounting is not high-quality accounting; it is biased in the other direction and can flatter later periods.
  6. The takeawayAccruals growing faster than revenue are a signal to dig deeper, not proof of fraud.
Practise FSA.10

FSA.11Ratios, DuPont and comparative analysis

  • Tools: ratios, common-size analysis (vertical and horizontal), trend analysis, graphs and comparison with peers; ratios depend on accounting choices and need context.
  • Activity: inventory turnover = cost of sales / average inventory; days of inventory on hand = 365 / turnover; receivables turnover = revenue / average receivables.
  • Liquidity, solvency (debt ratios, interest coverage = EBIT / interest) and profitability (margins, ROA, ROE).
  • Three-part DuPont: ROE = net profit margin x asset turnover x financial leverage.
  • Five-part DuPont splits margin into tax burden (NI / EBT), interest burden (EBT / EBIT) and EBIT margin.
  • Industry-specific ratios include same-store sales for retailers and capital adequacy for banks.
  1. The situationNet income 120, revenue 2,000, average assets 1,600, average equity 800.
  2. Step 1Margin = 120 / 2,000 = 6%; turnover = 2,000 / 1,600 = 1.25; leverage = 1,600 / 800 = 2.0.
  3. Step 2ROE = 6% x 1.25 x 2.0 = 15%, matching 120 / 800.
  4. Where questions turnA rising ROE driven only by leverage carries more risk than one driven by margin or turnover.
  5. The takeawayDuPont shows whether ROE comes from profitability, efficiency or borrowing.
Practise FSA.11

FSA.12Forecasting with pro forma models

  • A sales-based pro forma model forecasts revenue first, then costs, working capital and capital spending as ratios or drivers of revenue.
  • Separate fixed from variable costs so that margins respond correctly to volume changes.
  • Analyst biases include overconfidence, the illusion of control, anchoring, conservatism and confirmation; remedies include base rates, scenarios and seeking contrary evidence.
  • Five forces (rivalry, new entrants, substitutes, supplier power, buyer power) shape the price and cost assumptions.
  • With inflation, forecast price and volume separately and consider how far cost increases can be passed on.
  • Choose an explicit horizon long enough for the business to reach a steady state, then use a terminal assumption such as stable growth.
  1. The situationRevenue 1,000 grows 6%; cost of sales is 60% of revenue; SG&A is 200 fixed plus 5% of revenue.
  2. Step 1Revenue = 1,000 x 1.06 = 1,060; cost of sales = 636; gross profit = 424.
  3. Step 2SG&A = 200 + 53 = 253; operating profit = 424 - 253 = 171.
  4. Where questions turnStarting from last year's number and adjusting too little is anchoring, not caution.
  5. The takeawayThe fixed part of SG&A lifts operating margin as revenue grows.
Practise FSA.12

Key terms

Weighted average shares
Shares outstanding weighted by the fraction of the period each was outstanding.
Antidilutive
A potential share that would raise EPS if included, so it is left out of diluted EPS.
Recoverable amount
Under IFRS, the higher of fair value less costs of disposal and value in use.
Net realisable value
Estimated selling price less the costs to complete and sell.
LIFO reserve
The difference between inventory at FIFO and at LIFO (US GAAP).
Temporary difference
A gap between an item's carrying amount and its tax base that will reverse.
Free cash flow to the firm
Cash available to all capital providers after operating costs and investment.
Free cash flow to equity
Cash available to shareholders after investment and debt flows.
Right-of-use asset
A lessee's asset representing its right to use a leased item.
Channel stuffing
Pushing excess goods onto customers to pull revenue into the current period.

After this guide: You should be able to compute EPS, cash flows, inventory costs, impairments, deferred taxes and key ratios, and explain how a reporting choice changes the statements.

Practise Financial Statement Analysis

Built to the topics and weights CFA Institute publishes for the 2027 Level I curriculum. The module names, explanations, worked examples and traps are ExamDragon's own. Every source this path is built on.