FSA 1 Introduction to Financial Statement Analysis
Financial analysis is the work of interpreting and judging how a company is performing and where it stands, read against the economic setting it operates in. Analysts use it to reach decisions and recommendations, such as whether to buy a company’s debt or equity and at what price. A lender cares mostly about whether the borrower can pay interest and return the principal; an equity holder cares about profitability and the value attached to each share. The common thread is whether the business can earn a return on its capital that at least matches the cost of that capital, grow its operations profitably, and produce enough cash to cover its obligations and fund new opportunities.
The starting point is always the company’s financial reports: audited financial statements, the extra disclosures that regulators demand, and any unaudited commentary that management chooses to add. Analysts then widen the picture with research on the industry and the wider economy, because a single set of statements rarely explains why one firm outperformed another.
The six phases
Whatever the specific assignment, whether valuing equity, sizing up creditworthiness, judging a subsidiary, or screening for short candidates, the workflow follows the same generic path. The table below sets out each phase alongside the material that feeds it and what the phase is meant to produce.
| Phase | Main inputs | What it produces |
|---|---|---|
| Set the purpose and context | The role being served, instructions from a client or supervisor, and institutional guidelines | A stated objective, a list of questions to answer, the report format, and a timetable with a resource budget |
| Collect data | Financial statements and other financial data, questionnaires, industry and economic figures, discussions, and site visits | Financial and other data in a workable form such as a spreadsheet, plus any completed questionnaires |
| Process data | The data gathered in the previous phase | Adjusted statements, common-size statements, ratios, and charts |
| Analyze and interpret | The raw inputs together with the processed data | Analytical findings, forecasts, and valuations |
| Communicate conclusions | Analytical findings, earlier reports, and guidelines for published work | A report answering the phase-one questions and a recommendation, for example to invest or extend credit |
| Follow up | New information gathered by repeating the earlier steps as needed | Actual results checked against expectations, revised forecasts, and updated recommendations |
A generic framework applied across equity, credit, and other analytical roles.
Setting purpose and context
Knowing why the analysis is being done matters especially here, because the number of available techniques and the sheer volume of data can pull a less experienced analyst into calculating ratios before asking what any of them would decide. Some tasks are tightly defined, such as a routine credit review of an investment-grade portfolio, so the purpose, format, and sources are effectively handed to the analyst. Others are open, and the analyst must choose the approach, tools, data sources, reporting format, and the weight to give each part of the work. A useful discipline is to ask: if every ratio were available instantly, which question would it let me answer, and which decision would that support. Context means naming the audience, the deliverable, the deadline, and any resource limits. Only after purpose and context are clear should the analyst list the precise questions to be answered, for example the relative growth and profitability of a set of peers.
Collecting, processing, and interpreting
Collecting data centers on understanding the target’s business model, performance, and position, including trends over time and against peers. Statement data alone can be enough for a simple screen, such as finding firms above a minimum profitability or growth level, but deeper questions need more. Analysts often work top down: read the macroeconomic outlook, then the prospects for the industry given that macro backdrop, then the prospects for the company given both. Processing turns the raw material into tools: ratios, growth rates, common-size statements, charts, regressions or simulations, forecasts, valuations, and sensitivity tests. Interpreting is the step that gives those outputs meaning, because a bare number seldom answers the question; the analyst reads the output to support a conclusion, such as a buy, hold, or sell call built on forecast earnings, projected free cash flow, and a spread of fair-value estimates.
Communicating and following up
The conclusion has to be delivered in a format that suits the task, the institution, and the audience. An external equity report would typically carry a summary and investment conclusion, an industry and competitive overview, a financial model with scenarios, a valuation, and a statement of investment risks. Professional standards also shape content: the CFA Institute Standards of Practice Handbook, under Standard V(B), requires members to communicate the factors that drove a recommendation, to separate opinion from fact clearly, to disclose limitations and risks, and to include the elements a reader needs to judge the conclusion independently. The process does not stop at the report. Once an investment is made or a rating assigned, periodic review revises forecasts and recommendations as new information arrives, and even a rejected idea may need fresh work if prices or conditions shift.
Two analysts are debating where certain activities belong in the framework.
Financial statement analysis exists to take the reports a company publishes, combine them with other information, and judge the firm’s past, present, and likely future performance and position, all in service of an investment, credit, or other economic decision. Managers inside the firm also analyze results to guide operating, investing, and financing choices, but they draw on nonpublic information as well, so their process is not confined to the published statements.
Decisions the analysis serves
Analysts usually have a specific decision in view. Typical examples include selecting an equity holding for a portfolio, valuing a security to recommend it to others, gauging creditworthiness before extending a loan and setting its terms, assigning a debt rating to an issuer or a bond, weighing a venture capital or other private equity stake, and evaluating a merger or acquisition target. Across all of these, the recurring aim is to study past and current results and position in order to form expectations about the future, while staying alert to the factors that put that future at risk. Performance work commonly centers on profitability, meaning the capacity to make money from supplying goods and services, and on the strength to generate positive cash flow, that is, receipts running ahead of disbursements.
Earnings, expectations, and valuation
Reported earnings are read not in isolation but against what the market expected, and news coverage tends to frame results that way. Earnings also feed valuation directly: an analyst may compare a company’s price-to-earnings ratio with those of its peers, or use forecast earnings inside a discounted cash flow model. Consider the second-quarter 2022 release from Sea Limited, a Singapore-based technology company. GAAP revenue reached US$2.9 billion, a gain of 29.0 percent year on year, while gross profit came to US$1.1 billion, higher by 17.1 percent. Yet the total net loss was US$(931.2) million, wider than the US$(433.7) million loss a year earlier, and adjusted EBITDA was US$(506.3) million against US$(24.1) million. Within that, the e-commerce arm grew GAAP revenue to US$1.7 billion, up 51.4 percent, and management chose to suspend full-year e-commerce revenue guidance, citing macro uncertainty.
Financial position and credit
For credit work the emphasis shifts to financial position and the ability to service debt. Rating agencies package that judgement into a letter grade. In 2022, for instance, T-Mobile reached its first full investment-grade standing after S&P assigned BBB- with a positive outlook, after Moody’s had assigned a Baa3 rating with a stable outlook and Fitch a BBB- with a positive outlook. Moody’s tied its upgrade to faster-than-expected cost synergies from the April 2020 Sprint merger and a clear path toward keeping adjusted leverage below about 3.75 times, alongside rising free cash flow. Grades of this kind condense a large amount of position and cash-flow analysis into a signal that lenders and bond investors can act on.
Using the Sea Limited second-quarter 2022 release above and the news coverage of it, a junior analyst must explain the market reaction. The company reported revenue of US$2.9 billion against a consensus estimate of US$2.98 billion, and a loss of 61 cents per share against an estimated loss of US$1.14 per share. The e-commerce unit accounts for roughly 60 percent of revenue and the Garena gaming unit roughly 31 percent. On the day, the shares fell 14.3 percent, and they were down about 62 percent for the year.
Regulators require publicly traded issuers to report under specified accounting standards and securities laws. Approaches differ by jurisdiction, yet regulators responsible for over 95 percent of the world’s financial markets belong to the International Organization of Securities Commissions, which lends a degree of global consistency. This section covers that regulatory backdrop and then the four kinds of regulated disclosure an analyst leans on most: filings, notes and schedules, management commentary, and the audit report.
IOSCO and national regulators
Formed in 1983, IOSCO is not itself a regulator but its members regulate upwards of 95 percent of global financial capital markets across more than 115 jurisdictions, with emerging-market bodies making up 75 percent of its ordinary membership. Its Objectives and Principles of Securities Regulation rest on three core aims: protecting investors, keeping markets efficient, transparent, and fair, and holding down systemic risk. The principles are grouped into ten categories; two of the issuer principles bear directly on reporting, calling for full, accurate, and timely disclosure of material information, and for accounting standards of a high, internationally acceptable quality.
In the United States the Securities and Exchange Commission holds primary responsibility for securities regulation and is an ordinary IOSCO member. Created by reforms after the 1929 crash, it enforces, among others, the Securities Act of 1933 (mandating the information investors must receive when securities are sold and requiring registration of public issuances), the Securities Exchange Act of 1934 (which created the SEC and empowered it to require periodic reporting), and the Sarbanes-Oxley Act of 2002 (which established the Public Company Accounting Oversight Board, tightened auditor independence, and made executives certify their reports and the effectiveness of internal control). Companies comply mainly by filing standardized forms; more than 50 form types exist. In the European Union, each member state regulates its own market, but since 2005 the consolidated accounts of EU-listed companies must use IFRS, and two bodies, the European Securities Committee and the European Securities and Market Authority, advise on and help coordinate supervision.
| Filing | Purpose for the analyst |
|---|---|
| Registration statement | Filed when securities are offered; covers the securities offered, links to other capital, annual-type disclosures, recent audited statements, and business risk factors |
| Forms 10-K, 20-F, 40-F | Annual reports (US, non-US, and certain Canadian issuers) with audited statements, notes, MD&A, and the auditor’s report |
| Annual report to shareholders | A company-prepared document, not an SEC requirement, often a polished marketing piece that overlaps heavily with the 10-K |
| Proxy statement (DEF-14A) | Sent before shareholder meetings; discloses voting proposals, insider ownership, director backgrounds, and executive compensation |
| Forms 10-Q and 6-K | Interim reports (quarterly for US, semiannual for many non-US issuers) with unaudited statements and an MD&A |
| Form 8-K (6-K) | Current report announcing material events such as acquisitions, disposals, or governance changes |
| Forms 3, 4, 5, and 144 | Report beneficial ownership and insider trades for directors, officers, and holders of more than 10 percent of a class of equity |
| Form 11-K | Annual report of employee stock purchase and savings plans |
Notes, schedules, and segment reporting
The notes that accompany the statements are required and frequently make up a large share of the disclosure; Sea Limited’s 2021 statements ran to more than 60 pages of notes. They set out the basis of preparation (Sea reports under US GAAP on a consolidated basis, in thousands of US dollars, with a calendar fiscal year) and the accounting policies, methods, and estimates used. Both IFRS and US GAAP allow some choice among policies so that reporting can fit each firm’s circumstances, but that flexibility cuts comparability: two firms buying similar equipment may depreciate it under different methods, and the analyst has to understand the choices to adjust for them. Notes also cover items such as segment reporting, acquisitions and disposals, on- and off-balance-sheet obligations, financial instruments and their risks, subsequent events, related-party transactions, and legal proceedings.
Companies do not publish full statements for every business, but under both frameworks they disclose disaggregated data by operating segment. An operating segment is a component that may earn revenue and incur expense (including a start-up yet to earn revenue), whose results senior management reviews regularly, and for which discrete financial information exists. A segment must be reported separately once it reaches 10 percent or more of the combined segments’ revenue, assets, or profit, where the profit test uses the absolute value against the greater of total profits of profitable segments or total losses of loss-making segments. If the reportable segments together fall short of 75 percent of company revenue, more segments are added until that level is met; the remainder is grouped as all other segments. Disclosures per segment include revenue split between external and inter-segment, a profit or loss measure, assets and liabilities where reviewed, interest revenue and expense, capital spending on property and intangibles, depreciation and amortization, other non-cash items, income tax, and any equity-method results, plus a reconciliation to the consolidated totals. A separate rule requires disclosure whenever any single customer supplies 10 percent or more of revenue, though not that customer’s identity.
| Digital Entertainment | E-Commerce | Digital Financial Services | Other Services | Unallocated | Consolidated | |
|---|---|---|---|---|---|---|
| Revenue | 4,320,013 | 5,122,959 | 469,774 | 42,444 | 0 | 9,955,190 |
| Operating income (loss) | 2,500,081 | (2,766,566) | (640,422) | (177,633) | (498,520) | (1,583,060) |
Excerpt from Note 22 (Segment Reporting), Sea Limited 2021 Form 20-F. Net loss for the year was (2,043,030) after non-operating loss, income tax, and equity-method results.
| Region | 2019 | 2020 | 2021 |
|---|---|---|---|
| Southeast Asia | 1,378,141 | 2,791,894 | 6,316,782 |
| Latin America | 282,618 | 790,308 | 1,850,861 |
| Rest of Asia | 489,291 | 655,007 | 1,394,342 |
| Rest of the World | 25,328 | 138,455 | 393,205 |
| Consolidated | 2,175,378 | 4,375,664 | 9,955,190 |
Management commentary
Regulatory filings such as the 10-K and 10-Q carry a section, known variously as management commentary, the operating and financial review, or MD&A, in which management discusses the business, past results, and outlook. Apart from figures drawn from the statements, this material is generally unaudited, though Germany has required audited management reporting since 1931. To lift its quality, the IASB issued an IFRS Practice Statement on Management Commentary that offers a framework rather than a binding standard, naming five content elements of decision-useful commentary: the nature of the business; management’s objectives and strategies; the firm’s significant resources, risks, and relationships; results of operations; and critical performance measures. Within the United States, the SEC specifies MD&A content, requiring management to flag favorable and unfavorable trends, events and uncertainties affecting liquidity, capital resources, and results, effects of inflation and changing prices, off-balance-sheet obligations, contractual commitments, and the critical accounting policies that call for subjective judgement. The commentary is a good starting point, and its forward-looking parts help in projecting performance, but it remains one input among several for an independent view.
Auditor’s reports
Statements in an annual report must generally be audited by an outside firm under specified auditing standards, and the auditor then issues a written opinion, the audit report. International Standards on Auditing, which the International Auditing and Assurance Standards Board produces, are used in many countries; the United States sets its own, promulgated for public companies by the PCAOB since Sarbanes-Oxley. Because audits rely on sampling and the statements themselves rest on estimates, an auditor cannot give absolute assurance; the report provides reasonable assurance that the statements are fairly presented, meaning a high probability that they are free of material error, fraud, or illegal acts affecting them directly.
| Opinion | What it signals |
|---|---|
| Unqualified (clean) | The statements give a true and fair view, or are fairly presented, under the applicable standards; the outcome analysts want to see |
| Qualified | A scope limitation or a specific exception to the standards, described in added explanatory paragraphs so its importance can be judged |
| Adverse | The statements depart materially from the standards and are not fairly presented |
| Disclaimer | The auditor cannot form an opinion, for example because of a scope limitation |
The report also states the basis for the opinion and, for listed companies, discusses Key Audit Matters (international) or Critical Audit Matters (United States), being issues involving higher risk of misstatement, significant judgement, or major transactions, though these are not necessarily what matters most to analysts. Under Sarbanes-Oxley the auditor also opines on internal control over financial reporting, and management must accept responsibility for that control, evaluate it against suitable criteria, support the evaluation with evidence, and report on it. Sea Limited received an unqualified opinion from Ernst and Young for the year ended 31 December 2021, in a report dated 22 April 2022; the firm noted it had served as auditor since 2010. Even so, these attestations are not infallible, and a measure of healthy skepticism remains essential.
In September 2017, Sea Limited lodged a registration statement with the US SEC ahead of listing its initial public offering on the New York Stock Exchange, adding more than 50 pages on its business and industry to a large body of financial information.
Use the Sea Limited segment and geography tables above, with consolidated 2021 revenue of 9,955,190 thousand USD.
An auditor concludes that a company’s statements follow the applicable accounting standards in every respect except for how inventory is reported.
Most countries outside the United States now require IFRS, which has pushed global reporting toward convergence, yet meaningful differences remain in the world’s capital markets. The gap that matters most is between IFRS and US GAAP, since a large share of listed companies report under one or the other. The IASB and FASB coordinate changes and try to narrow the differences: broad convergence of the conceptual frameworks and existing standards was paused in the late 2000s, but most major new standards, covering areas such as revenue recognition, leasing, and credit losses, have been largely or fully converged, and maintaining that on future standards stays a priority for both boards.
| Basis for comparison | US GAAP | IFRS |
|---|---|---|
| Developed by | FASB | IASB |
| Orientation | Rules | Principles |
| Interest paid | Operating cash flows | Financing or operating cash flows |
| Inventory valuation | FIFO, LIFO, and weighted average | FIFO and weighted average |
| Development cost | Expensed | Capitalized only if certain conditions are met |
| Reversal of inventory write-down | Prohibited | Permitted if specified conditions are met |
Because reconciliation between the two frameworks is not required, an analyst comparing companies on different standards must know where the standards have not converged. Often the user lacks enough information to make the exact adjustments that would restore comparability, so caution is warranted when reading measures produced under different regimes, along with ongoing attention to standard-setting, since changes can move both reported results and valuations.
Monitoring developments
Analysts should track reporting developments and judge their effect on analysis and valuation, but from a user’s point of view rather than a preparer’s; the aim is to know how a change will alter the reports, not to become an accountant. Three habits help. First, watch new products and transactions, which can carry features that existing standards do not clearly address, often arising from new businesses such as fintech or new instruments such as digital assets, and note that when one firm in an industry adopts something new, peers tend to follow. Second, follow the actions of standard setters and regulators; they lag new products, but their rulings can reshape reports and valuations, for instance when the expensing of employee stock options moved a dilutive cost from the notes into the income statement, which can matter for any investor who does not read the notes closely. Third, review company disclosures on critical accounting policies and estimates. Both the IASB and FASB publish extensive material on proposed changes and invite comment through exposure drafts, and CFA Institute participates actively through liaison committees, comment letters, and position papers, including its 2007 A Comprehensive Business Reporting Model, which argued for fair-value information, neutrality, and detailed cash flow reporting through the direct-format cash flow statement.
An accountant follows new rules to apply them correctly in preparing statements. An analyst follows the same rules to anticipate how reported numbers will change, so that comparisons across time and across companies stay valid and valuation inputs are not distorted by an accounting shift. The user’s question is always what the change does to the reports being analyzed.
Beyond regulated filings and notes, analysts draw on a wide range of material. It helps to group these sources by where they originate: the issuer, public third parties, proprietary third parties, and the analyst’s own primary research. Information on the economy, the industry, and peers is often what puts a company’s results in perspective and, in many cases, is essential to an analyst’s effectiveness.
Issuer sources beyond filings
Companies communicate in ways that go past required reports. Earnings calls are webcast or teleconferenced presentations with a question-and-answer session, hosted by management to discuss results; they are not legally required, but most public companies hold them to explain gaps against expectations, revise targets, and describe actions such as acquisitions or restructurings, and analysts use the questions to sharpen their estimates. Investor days and similar events offer deeper presentations on the business or particular segments, again with a management bias to work around. Press releases announce events, product changes, personnel moves, and deals, and often appear on third-party news sites as well as the company’s own. Analysts also speak with management, investor relations, and other staff, and can experience a company’s products directly as a customer, which is not always feasible, as with pharmaceuticals.
Third-party and primary research
Public third-party sources include free industry white papers or analyst reports from consultancies, economic and industry indicators from governments and other bodies, general and industry-specific news, and social media as a gauge of customer sentiment. Proprietary third-party sources include paid analyst reports and communications, including from sell-side analysts and credit rating agencies, data platforms such as Bloomberg, Wind, and FactSet, and specialist consultancies focused on particular industries. Proprietary primary research is information the analyst generates directly, through surveys, conversations, product comparisons, and other studies. A consumer-facing company invites hands-on product experience; a regulated industry calls for study of current and expected rules; a technical field calls for expertise built personally or drawn from a specialist.
An analyst is sorting several pieces of information by where each is found.