Basics of Financial Statement Analysis (FSA) | CFA Level 1

The Financial Statement Analysis (FSA) introduces the core concepts required to evaluate a company’s financial performance and future prospects, with a strong focus on the Cash Flow Statement and Inventory Valuation.

These topics help analysts understand cash generation, operational efficiency, profitability, and the impact of inventory methods like FIFO, LIFO, and Weighted Average on financial reporting and decision-making.

Cash Flow Statement

The Cash Flow Statement provides a comprehensive view of a company's cash inflows and outflows over a specific period, detailing where cash is generated and how it is used.

Purpose and Importance

• Illustrates Cash Movement: Unlike the Profit and Loss Account which shows Net Profit based on the accrual principle, the Cash Flow Statement focuses purely on cash transactions.

• Identifies Financial Health Issues: A company might show high Net Profit but low cash. This is a significant concern because cash is essential for daily operations. A large disparity between reported profit and available cash can indicate financial distress or manipulation.

• Stakeholder Interest: Shareholders and lenders closely monitor cash generation and usage to assess stability and solvency.

• Fraud Detection: This statement became mandatory after historical cases of financial manipulation where companies showed high profits without corresponding cash, as manipulating cash transactions is generally more difficult than manipulating sales or expenses.

Components of a Cash Flow Statement

The Cash Flow Statement starts with Opening Cash and adds or subtracts cash flows from three main activities to arrive at Closing Cash.

Formula:

Opening Cash + Cash Flow from Operations (CFO) + Cash Flow from Investing (CFI) + Cash Flow from Financing (CFF) = Closing Cash

1. Cash Flow from Operations (CFO)

• This relates to the company's core, main business activities (Memory Tip: Think of "Operations" as the company's core business).

• Cash Inflows: From selling goods, providing services, commissions, or royalties.

• Cash Outflows: Payments to suppliers, staff salaries, wages, taxes, interest, and other day-to-day operating expenses.

• Pedagogical Emphasis: CFO is the most crucial component. A consistently negative CFO for a mature company is a significant negative sign, indicating reliance on external financing or asset sales. A positive CFO is vital for long-term survival and growth.

2. Cash Flow from Investing (CFI)

• This involves activities related to long-term assets (Memory Tip: Think of "Investing" as activities related to long-term assets).

• Cash Inflows: From selling long-term assets like machinery, land, or buildings.

• Cash Outflows: From purchasing long-term assets.

• Pedagogical Emphasis: A negative CFI alongside a positive CFO can be a positive sign for a growing company, as it indicates investment in assets for future growth.

3. Cash Flow from Financing (CFF)

• This covers activities related to how a company raises and repays capital (Memory Tip: Think of "Financing" as activities related to how a company raises and repays capital).

• Cash Inflows: From issuing shares, taking on loans.

• Cash Outflows: Repaying loans, repurchasing shares (share buyback), paying dividends.

Example Calculation of Closing Cash:

If Opening Cash = 1000, CFO = +700, CFI = +300, CFF = -500

Closing Cash = 1000 + 700 + 300 - 500 = 1500

Transparency and Analysis

Companies provide financial reports to ensure transparency. As an analyst, one must look beyond the numbers to understand performance and prospects. Cash is the King – it determines a company's ability to meet obligations and grow.

Inventory Valuation

Inventory refers to goods a company has produced or acquired but has not yet sold. It is reported as an asset on the Balance Sheet.

Forms of Inventory

Inventory can exist in three main forms:

1. Raw Material: Basic inputs not yet manufactured (e.g., wood for furniture).

2. Work In Progress (WIP): Partially completed goods in production (e.g., a half-built table).

3. Finished Goods: Completed products ready for sale but unsold (e.g., a fully assembled table).

Inventory Valuation Principle

Inventory is valued at the lower of Cost or Net Realizable Value (NRV).

• Cost: The original cost incurred to produce or acquire inventory.

• Net Realizable Value (NRV): The net cash expected from selling the inventory (Memory Tip: NRV reflects the net cash expected from selling the inventory).

• Formula: Selling Price - Selling Costs (e.g., if a chair sells for $105 with $15 in selling costs, NRV is $90).

• Application: If an item costs $100 but its NRV is $90, it is reported at $90 on the Balance Sheet.

Methods of Inventory Valuation (for homogeneous goods)

For identical inventory items, companies use specific methods to determine the Cost of Goods Sold (COGS) and ending inventory, especially when purchase prices change.

1. First-In, First-Out (FIFO)

• Assumption: The oldest goods purchased are the first ones sold (Memory Tip: "First In First Out" – what came in first, goes out first).

• Impact (in rising price environment):

• Cost of Goods Sold (COGS): Lower (as cheaper, older goods are assumed sold).

• Ending Inventory: Higher (as more expensive, newer goods are assumed to remain).

• Example (10 @ $1, 10 @ $2, 10 @ $3; 20 units sold, 10 remain):

• COGS (20 units): (10 units * $1) + (10 units * $2) = $10 + $20 = $30

• Ending Inventory (10 units): (10 units * $3) = $30

2. Last-In, First-Out (LIFO)

• Assumption: The newest goods purchased are the first ones sold (Memory Tip: "Last In First Out" – what came in last, goes out first).

• Impact (in rising price environment):

• Cost of Goods Sold (COGS): Higher (as more expensive, newer goods are assumed sold).

• Ending Inventory: Lower (as cheaper, older goods are assumed to remain).

• Example (10 @ $1, 10 @ $2, 10 @ $3; 20 units sold, 10 remain):

• COGS (20 units): (10 units * $3) + (10 units * $2) = $30 + $20 = $50

• Ending Inventory (10 units): (10 units * $1) = $10

3. Weighted Average Cost

• Assumption: The average cost of all goods available for sale is applied to both COGS and ending inventory.

• Calculation: Total Cost of Goods Available for Sale / Total Units Available for Sale.

• Example (from 10 @ $1, 10 @ $2, 10 @ $3):

• Total Cost = ($10*1) + ($10*2) + ($10*3) = $60

• Total Units = 30

• Average Cost Per Unit = $60 / 30 = $2

• COGS (20 units): 20 units * $2 = $40

• Ending Inventory (10 units): 10 units * $2 = $20

Comparative Analysis: FIFO vs. LIFO

A quick comparison of FIFO and LIFO, highlighting their impact on cost of goods sold, profit, ending inventory value, and tax liability.

Pedagogical Emphasis and Importance for Analysis

Companies choose inventory methods, often disclosing them. In a typical scenario with rising prices, LIFO results in a higher COGS and lower reported profit, which can lead to tax savings. If a company seeks to show higher profits, it might prefer FIFO. 

Crucial for Comparability: When comparing companies using different inventory methods, adjustments are necessary for a true performance picture. This comparison, especially its impact on COGS, profit, and inventory value, is a frequently tested concept in financial analysis 

(Memory Tip: Use simple numbers (e.g., 1, 2, 3) to illustrate and remember the effects of FIFO and LIFO on COGS and ending inventory. For FIFO, ending inventory is based on the latest prices (3), while COGS is based on earlier prices (1 and 2), making COGS lower. For LIFO, the reverse occurs).