Financial Statement Analysis (FSA) is one of the most heavily weighted topics. It covers the analysis of income statements, balance sheets, and cash flow statements, along with financial ratios, revenue recognition, inventory accounting, long-lived assets, and financial reporting quality.
Financial statements are prepared under either IFRS (International Financial Reporting Standards) or US GAAP (Generally Accepted Accounting Principles). Key differences include inventory methods (LIFO allowed under GAAP but not IFRS), development costs (capitalized under IFRS if criteria met, expensed under GAAP), and classification of certain items on the cash flow statement. The conceptual framework defines qualitative characteristics: relevance, faithful representation, comparability, verifiability, timeliness, and understandability.
The income statement reports revenues, expenses, and profits over a period. Revenue recognition follows the five-step model: identify the contract, identify performance obligations, determine the transaction price, allocate the price, and recognize revenue when obligations are satisfied. Key metrics include gross profit margin, operating profit margin, and net profit margin. Earnings per share (EPS) is reported as both basic and diluted.
The balance sheet reports assets, liabilities, and equity at a point in time (Assets = Liabilities + Equity). Current vs. non-current classification affects liquidity analysis. Key areas include inventory valuation (FIFO vs. LIFO vs. weighted average), accounts receivable (allowance for doubtful accounts), and long-lived assets (depreciation methods and impairment). Off-balance-sheet items like operating leases (now largely on-balance-sheet under IFRS 16/ASC 842) require careful analysis.
The cash flow statement reconciles net income to actual cash flows across three categories: operating (day-to-day business), investing (long-term assets), and financing (debt and equity). It can be prepared using the direct method (listing actual cash receipts and payments) or indirect method (adjusting net income for non-cash items). Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are key valuation inputs.
Financial ratios are grouped into five categories: (1) Liquidity — current ratio, quick ratio; (2) Solvency — debt-to-equity, interest coverage; (3) Profitability — ROE, ROA, net margin; (4) Activity/Efficiency — inventory turnover, receivables turnover; (5) Valuation — P/E, P/B, EV/EBITDA. DuPont analysis decomposes ROE into profit margin × asset turnover × financial leverage.
Measures short-term liquidity — ability to meet obligations within one year.
More conservative liquidity measure excluding inventory.
Decomposes return on equity into profitability, efficiency, and leverage components.
Measures financial leverage — how much debt finances the company relative to equity.
Measures how quickly inventory is sold. Higher turnover indicates efficient inventory management.
Earnings attributable to each common share outstanding.
Free cash flow to the firm: cash available to all capital providers.
Decomposes ROE into three components to identify drivers of profitability.
Understanding how the three financial statements connect.