Since decades, every working setup has a room stacked with files, shelves loaded with piles of papers and dust. It is a regulatory necessity for most organisations to keep historical records if these are opened ever, what is the most common paperwork that will be unanimous across organisations? Historical Financials !!
Financial Reporting is done by any firm for two purposes: Keeping records of the financials and using these records to analyse the performance of the organisation. What are the financial documents that are required to be recorded and why?
- Balance Sheet – This is a document that lets the reader know about the position of the firm. One gets to know what all liabilities an organisation has and how are they planning to pay those.
- Income Statement – This document lets the reader know about the performance of the organisation. It is a reflection of the operating performance of the organisation, showing the income earned and expenses incurred by the firm.
- Cash Flow – While Income statement is on an accrual basis, the cash flow statement shows the inflow and outflow of cash just not in the operational domain but in investments too
Financial Reporting Analysis portion of CFA Level 1 will basically cover these three financial statements in detail. Each line item of all the statements will be discussed in detail. Some areas will be given more importance like Inventory, Lease and Tax due to their significance in the practical world.
How it differs from general accounting?
Accounting is about preparing financial statements and passing general entries, FRA is about analysing financial statements and finding inferences. It involves in-depth understanding of why and where a certain line item is coming from. If you are able to answer all why’s you are able to analyse statements well.
FRA is one of the most important subjects in the CFA level 1 exam, it’s importance is also derived from the fact that it is interconnected to other important subjects like corporate finance and equity. To be a good financial Analyst, this is the root that one needs to grow in depths.
Using these financial statements, calculate the profitability ratios (ROE, After-tax Operating Profit Margin, Net Profit Margin).
- Effective Tax Rate= 851/3544 =24.0% 3544
- Operating Profit Margin = (12446 – 8766)(1 – .240)/27799) = 2796.8/27799 = 10.06
- Net Profit Margin= 2693/ 27799 =9.69%
- Return on Equity = 2693/11081 = 24.30%
This is just a snapshot of what FRA would put on your plate, there is definitely more to it. You get to understand the treatment of some important items, which are necessities for an analyst:
- Inventory Management
- Lease Analysis
- Deferred Tax Treatment
- Long-Term Assets
All the items on balance sheet and Income statement are analysed in great detail and most importantly, all WHY’s are answered. Level 1 in FRA prepares you as an analyst to understand the position of a company by answering all WHY ’s! Remember, as an analyst, if you are looking at a Financial statement of a company and not figuring out the answers for WHY’s, you aren’t doing your job to the fullest! For eg.
- Why is the current ratio low?
- Why is PAT negative?
- Why is the depreciation increasing?
Apart from, helping one understand the position of a company, this portion of the CFA curriculum help you find the manipulations that can be done while preparing statements. This is where CFA’s are differentiated from CFA’s, they don’t just have the capability of making financial statements but the logic to analyse it.
Coming back to the FRA part of Level 1 exam, it has the highest weightage in the exam, so the time and effort needed for it is well understood. Having said that, grasping this topic can be relatively easier for people from accounting background and they can afford to give less time.
A challenge that most people face while reading this curriculum is memorising the difference between IFRS and GAAP. The difference is however just not to be memorised but to be applied, as the treatment of different items differs as per both standards.
As mentioned earlier, there will be interconnections found too, in the entire CFA curriculum across all three levels. This is the first level, so the candidates need to get used to this fact as soon as possible. The first step would be here, using Time Value of Money from Quantitative Methods topic to FRA.
Practice is the key, memorising the formula’s isn’t. Reading the questions properly also is the ket, eg – until mentioned, answer the question according to IFRS.
Tip – More than cracking this topic in the exam, cracking the logic to it will be useful in your career as an analyst!