Integration of Financial Statement Analysis Techniques

2024 Curriculum CFA Program Level II Financial Reporting and Analysis

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Introduction

It is important to keep in mind that financial analysis is a means to an end and not the end itself. Rather than try to apply every possible technique and tool to every situation, it is essential for the investor to consider and identify the proper type of analysis to apply in a given situation.

The primary reason for performing financial analysis is to help in making an economic decision. Before making such decisions as whether to lend to a particular long-term borrower or to invest a large sum in a common stock, venture capital vehicle, or private equity candidate, an investor or financial decision-maker wants to make sure that the probability of a successful outcome is on his or her side. Rather than leave outcomes to chance, a financial decision-maker should use financial analysis to identify and make more visible potential favorable and unfavorable outcomes.

The purpose of this reading is to provide examples of the effective use of financial analysis in decision making. The framework for the analysis is shown in . The case study follows the basic framework shown in .

Exhibit 1. A Financial Statement Analysis Framework Phase Sources of Information Examples of Output

Define the purpose and context of the analysis.

The nature of the analyst’s function, such as evaluating an equity or debt investment or issuing a credit rating
Communication with client or supervisor on needs and concerns
Institutional guidelines related to developing specific work product

Statement of the purpose or objective of the analysis
A list (written or unwritten) of specific questions to be answered by the analysis
Nature and content of report to be provided
Timetable and budgeted resources for completion

Collect input data.

Financial statements, other financial data, questionnaires, and industry/economic data
Discussions with management, suppliers, customers, and competitors
Company site visits (e.g., to production facilities or retail stores)

Organized financial statements
Financial data tables
Completed questionnaires, if applicable

Process input data, as required, into analytically useful data.

Data from the previous phase

Adjusted financial statements
Common-size statements
Ratios and graphs
Forecasts

Analyze/interpret the data.

Input data and processed data

Analytical results

Develop and communicate conclusions and recommendations (e.g., with an analysis report).

Analytical results and previous reports
Institutional guidelines for published reports

Analytical report answering questions posed in Phase 1
Recommendation regarding the purpose of the analysis, such as whether to make an investment or grant credit

Follow-up.

Information gathered by periodically repeating above steps, as necessary, to determine whether changes to holdings or recommendations are necessary

Updated reports and recommendations

Learning Outcomes

The member should be able to:

demonstrate the use of a framework for the analysis of financial statements, given a particular problem, question, or purpose (e.g., valuing equity based on comparables, critiquing a credit rating, obtaining a comprehensive picture of financial leverage, evaluating the perspectives given in management’s discussion of financial results);
identify financial reporting choices and biases that affect the quality and comparability of companies’ financial statements and explain how such biases may affect financial decisions;
evaluate the quality of a company’s financial data and recommend appropriate adjustments to improve quality and comparability with similar companies, including adjustments for differences in accounting standards, methods, and assumptions;
evaluate how a given change in accounting standards, methods, or assumptions affects financial statements and ratios;
analyze and interpret how balance sheet modifications, earnings normalization, and cash flow statement related modifications affect a company’s financial statements, financial ratios, and overall financial condition.

Summary

The case study demonstrates the use of a financial analysis framework in investment decision making. Although each analysis undertaken may have a different focus, purpose, and context that result in the application of different techniques and tools, the case demonstrates the use of a common financial statement analysis framework. The analyst starts with a global, summarized view of a company and its attributes and digs below the surface of the financial statements to find economic truths that are not apparent from a superficial review. In the case of Nestlé, the analyst applied disaggregation techniques to review the company’s performance in terms of ROE and then successively examined the drivers of ROE in increasing detail to evaluate management’s skills in capital allocation.

An economic decision is reached, which is consistent with the primary reason for performing financial analysis: to facilitate an economic decision.

1.25 PL Credit

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