Financial statement analysis: follow the cash, then the accrual
Financial statement items become manageable when you decide which statement is speaking. Income can be earned before cash arrives. Cash can move without hitting earnings this period. The balance sheet is the stock; the income and cash flow statements are flows. CFA Drill writes original numbers so you practice that map—not so you memorize slogans.
1. A working order for any stem
- Identify the target: profitability, liquidity, leverage, coverage, or earnings quality.
- Write the identity (ROE decomposition, current ratio, interest coverage, CFO vs NI).
- Classify the account: operating vs investing vs financing when cash flow is involved.
- Plug the stem; if two choices are close, you usually missed a classification or a cost-flow assumption.
2. The three statements as one system
Net income flows to retained earnings (absent distributions and other equity moves). Cash flow reconciles why the cash line moved. If NI is strong but CFO is weak, ask whether working capital absorbed cash—receivables, inventory, payables—or whether non-cash gains inflated earnings.
Sample (original): Rising receivables and falling CFO while net income is up is a quality flag, not proof of a better business. Do not treat earnings as cash.
3. Ratio families (and what they cannot do)
- Liquidity — current and quick ratios; watch inventory quality and short-term debt.
- Solvency / leverage — debt ratios and coverage; higher leverage amplifies returns and losses.
- Profitability — margins and ROA/ROE; link to DuPont only when the stem gives the pieces.
- Activity — turnover ratios; rising days sales outstanding can explain cash strain.
Ratios are comparisons, not moral judgments. A “low” current ratio can be efficient or dangerous depending on industry, access to credit, and cash conversion.
4. Inventory and long-lived assets
Cost-flow assumptions (for example FIFO vs weighted average in many teaching examples) change COGS and ending inventory in opposite directions when prices move. In a rising-price environment, the method that assigns older, cheaper costs to COGS typically shows higher income—and higher ending inventory—than a method that expenses newer costs faster. Always state the price path before the slogan.
Depreciation methods change the path of expense, not the total cash paid for the asset. Accelerated methods front-load expense; straight-line spreads it. Impairment and revaluation rules vary by reporting framework—read the stem’s framework before importing a memory from another course.
Stem: Prices are rising. All else equal, which is most likely if a firm expenses newer inventory costs faster?
A. Lower COGS and higher taxable income this period
B. Higher COGS and lower income this period versus keeping older costs in COGS
C. No effect on COGS because inventory is a balance-sheet account only
Explanation: B. Expensing newer, higher costs raises COGS and lowers income relative to expensing older costs first.
5. Income taxes in one clear story
Book income and taxable income can differ in timing. Deferred tax assets and liabilities are the bridge for temporary differences. When enacted rates change, apply the new rate to the temporary differences that remain—do not leave the old rate on the balance sheet out of habit. Permanent differences do not create deferred taxes; they alter the effective rate.
6. Earnings quality: a short checklist
- NI versus CFO trend
- Receivables and revenue growth together
- One-time gains labeled as operating
- Aggressive capitalization of costs that peers expense
- Sudden estimate changes that lift earnings without cash
Quality analysis does not require accusing management. It requires separating sustainable cash generation from accounting presentation.
Stem: Management capitalizes a large portion of development costs that peers expense. Near-term NI may look stronger because:
A. Cash automatically rises by the same amount
B. Expense is deferred into future amortization rather than recognized immediately
C. Revenue must be higher under all reporting frameworks
Explanation: B. Capitalization defers expense; it does not create cash by itself.
7. Cash flow classification pitfalls
Interest and dividends can be classified differently depending on the reporting framework and policy choices described in the stem. Do not import a single country’s textbook default if the item specifies another treatment. When comparing two firms, mismatched classification can distort “operating” cash flow even when economics are similar.
8. Leases and off-balance-sheet intuition (high level)
Modern teaching often brings more lease obligations onto the balance sheet than older operating-lease storytelling. If a stem still contrasts on- versus off-balance presentation, focus on what happens to leverage ratios and expense timing—not on memorizing a slogan from an outdated edition.
9. Building an FSA drill loop
- Ten items: five ratio/identity, five quality/classification.
- For each miss, name the statement that should have spoken first.
- Once a week, mix FSA with Corporate Issuers so capital-structure stems do not feel foreign.
10. Practice
Use attempt first, then reverse-engineer the identity. More map: study guide. App: cfa-drill.com. Also: Ethics, Quant.