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Financial Statement Analysis

I. Lesson Focus

This lesson integrates the balance sheet, income statement, and statement of cash flows. Candidates must master the articulation between the three statements, compute and interpret key financial ratios, perform DuPont decomposition, calculate free cash flow, and understand the impact of accounting choices (capitalization vs. expensing, inventory methods, revenue recognition) on reported numbers and ratios.

II. The Problem

A company reports sharply higher net income, yet its operating cash flow is negative and leverage continues to rise. Investors cannot easily determine earnings quality or financial risk. The core task is to link the three financial statements, remove non-recurring items, recompute adjusted ratios, and assess whether management has used accounting discretion to improve the appearance of the reports. This is the practical heart of CFA Level I Financial Statement Analysis.

III. Core Articulations Among the Three Statements

The statements are interdependent and must satisfy these identities:

1. Balance Sheet Identity:
   Assets = Liabilities + Owners’ Equity

2. Link between Income Statement and Balance Sheet:
   Ending Retained Earnings = Beginning Retained Earnings + Net Income – Cash Dividends – Stock Dividends

3. Link between Cash Flow Statement and Balance Sheet:
   Ending Cash = Beginning Cash + CFO + CFI + CFF

4. Free Cash Flow to the Firm (FCFF):
   FCFF = NI + NCC + Int(1 – t) – FCInv – WCInv
   (NCC = non-cash charges, FCInv = fixed-capital investment, WCInv = working-capital investment)

IV. Comprehensive Ratio Framework

Ratios are grouped into four categories with clear numerator and denominator sources:

• Profitability: ROA = NI / Average Total Assets; ROE = NI / Average Equity; Net Profit Margin = NI / Revenue
• Liquidity: Current Ratio = Current Assets / Current Liabilities; Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
• Solvency: Debt-to-Assets = Total Liabilities / Total Assets; Interest Coverage = EBIT / Interest Expense
• Efficiency: Receivables Turnover = Revenue / Average Receivables; Inventory Turnover = COGS / Average Inventory; Total Asset Turnover = Revenue / Average Total Assets

DuPont Analysis (three-factor):
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
ROE = (NI / Revenue) × (Revenue / Avg Assets) × (Avg Assets / Avg Equity)

V. Impact of Accounting Adjustments

• Capitalizing vs. Expensing: Capitalization increases current-period profit, increases assets, and moves the cash outflow from operating to investing activities.
• Inventory Methods (FIFO vs. LIFO): In inflationary periods, LIFO produces higher COGS, lower net income, and lower ending inventory.
• Accelerated Revenue Recognition: Inflates current revenue and receivables, reduces future-period revenue.
• Non-recurring Items: Core earnings exclude one-time gains and losses.

Worked Cases

Case 1: Articulation and ROE Decomposition

ABC Corp. reports (in thousands): beginning assets 8,000, ending assets 9,200; beginning equity 4,800, ending equity 5,200; net income 720; revenue 4,800; dividends paid 200.
Calculate: (1) ROE, (2) DuPont decomposition, (3) possible reasons if CFO = –150.

Solution:
(1) Average equity = (4,800 + 5,200) / 2 = 5,000
ROE = 720 / 5,000 = 14.4%

(2) Net profit margin = 720 / 4,800 = 15.0%
Asset turnover = 4,800 / 8,600 ≈ 0.558
Equity multiplier = 8,600 / 5,000 = 1.72
ROE = 0.15 × 0.558 × 1.72 ≈ 14.4% (checks)

(3) Positive NI but negative CFO commonly results from large increases in receivables or inventory, or aggressive revenue recognition.

Case 2: Effect of Capitalization Policy Change

XYZ capitalizes R&D of 2 million (5-year life, tax rate 25%) instead of expensing. Original NI = 3 million, average assets = 5,000, ROA = 6%. What is adjusted ROA?

Solution:
Capitalization adds 2 m pre-tax profit. After-tax addition = 2 × (1 – 0.25) = 1.5 m.
Current amortization = 2 / 5 = 0.4 m; after-tax amortization = 0.4 × 0.75 = 0.3 m.
Adjusted NI = 3 + 1.5 – 0.3 = 4.2 million.
Assets increase by 2 – 0.4 = 1.6 m; new average assets ≈ 5,080.
Adjusted ROA = 4.2 / 5,080 ≈ 8.27% (materially higher than original 6%).

Case 3: Free Cash Flow and Sustainable Growth

Net income 15 m, depreciation 4 m, interest 3 m (tax 25%), capex 9 m, ΔWC = 2.5 m.
Compute FCFF. If dividend payout = 40% and ROE = 15%, what is sustainable growth rate?

Solution:
FCFF = 15 + 4 + 3 × (1 – 0.25) – 9 – 2.5 = 15 + 4 + 2.25 – 9 – 2.5 = 9.75 m

Retention ratio = 1 – 0.40 = 0.60
Sustainable growth g = ROE × retention = 0.15 × 0.60 = 9.0%

Traps

Key Formulas

• ROE = NI / Avg Equity
• ROA = NI / Avg Total Assets
• DuPont: ROE = (NI/Rev) × (Rev/Avg Assets) × (Avg Assets/Avg Equity)
• FCFF = NI + NCC + Int(1 – t) – FCInv – WCInv
• Ending RE = Beg RE + NI – Dividends
• Ending Cash = Beg Cash + CFO + CFI + CFF
• Interest Coverage = EBIT / Interest Expense
• Quick Ratio = (CA – Inventory) / CL

Practice Questions

Q1. A company reports net income of 5 million, average total assets of 40 million, and average equity of 25 million. Its ROE is closest to:
A. 12.5%　B. 20.0%　C. 15.0%　D. 8.0%

Q2. In an inflationary environment, using LIFO rather than FIFO will cause the company to report:
A. higher gross margin　B. lower inventory turnover　C. higher net income　D. lower debt-to-assets ratio

Q3. Which of the following is most likely to produce positive net income but negative operating cash flow?
A. Accelerated depreciation　B. Large increase in credit sales　C. Sale of fixed assets　D. Issuance of bonds

Q4. Using the three-factor DuPont model, if net profit margin is 10%, asset turnover is 1.2, and the equity multiplier is 1.5, ROE equals:
A. 15%　B. 18%　C. 12%　D. 21%

Q5. Classifying interest paid as a financing rather than operating cash flow will:
A. increase CFO　B. decrease CFO　C. change CFI but not total cash flow　D. have no effect

Q6. A firm capitalizes an expense of 2 million that should have been expensed (tax rate 30%, 20% amortized this year). Net income will be higher than under expensing by approximately:
A. 1.26 million　B. 1.40 million　C. 1.54 million　D. 2.00 million

Q7. Sustainable growth rate equals:
A. ROA × retention ratio　B. ROE × retention ratio　C. net profit margin × asset turnover　D. net profit margin × equity multiplier

Q8. Which adjustment is most likely to increase current-period ROA?
A. Increasing the bad-debt allowance　B. Capitalizing an operating lease　C. Capitalizing R&D expenditure　D. Switching to accelerated depreciation

Answers

Takeaways

• The three financial statements articulate through retained earnings, cash balances, and working-capital accounts; discrepancies signal errors or aggressive accounting.
• DuPont analysis links the income statement and balance sheet; the three factors must multiply back to reported ROE.
• Capitalizing expenditures improves reported profit and ROA/ROE in the short run but reduces operating cash flow.
• Always prefer average balance-sheet figures for ratios unless the vignette specifies otherwise.
• Cash-flow quality analysis focuses on differences between CFO and NI; large divergences require explanation.
• Adjusted “core” ratios that remove non-recurring items and standardize accounting choices provide the most useful basis for comparison and forecasting.