The CFA Program curriculum includes the following framework for financial statement analysis. It can be used to evaluate potential investments in a company’s securities, to determine a company’s credit-worthiness, or to evaluate the performance of its subsidiaries.
- Articulate the purpose and context of the analysis
- Collect input data
- Process data
- Analyze and interpret the processed data
- Develop and communicate conclusions and recommendations
- Follow up
The purpose and context of the analysis
Some analyses are well defined, such as estimating the value of a security. Others require decisions on the part of the analyst. In these cases, it is important to avoid unnecessary efforts by determining the scope of the analysis.
- What conclusion do you expect to draw?
- What question do you need to answer?
- What decision will your answer support?
- Who do you need to communicate your conclusions to?
- What is the deadline for your conclusion?
- What resources and constraints do you have?
Clarifying the scope of the analysis will help determine the specific research that must be done and questions that must be answered.
Collect input data
The obvious starting point are a company’s financial statements. These may be sufficient to answer simple questions, such as whether the company is profitable. To determine why the company is profitable, however, would likely require additional sources such as management commentary.
To aid effective decision making, raw data will not suffice. The data must be processed to become useful. This could include calculating financial ratios, preparing common-size financial statements, conducting regression or scenario analyses, creating charts, and other means of conveying the information effectively.
This starts with a basic understanding, through the financial statements and accompanying notes, of the accounting choices that have been made. It may then include adjustments to the reported data to facilitate comparisons. Finally, the adjusted data can be processed into useful ratios, charts, etc.
Analyze and interpret the data
The answers to specific analytical questions support, but are seldom sufficient for, conclusions. What estimates were used? How sensitive is the result to changes in assumptions? An full understanding of the data and how it might support other conclusions is necessary for a complete analysis.
Develop and communicate conclusions
A full analyst report will include a summary and investment conclusion, a business summary, an industry and competitive analysis, an analysis of risks, historical and projected performance, earnings forecasts, and a valuation. In many cases, regulators or company policies may require additional information. For example, the CFA Institute Standards of Professional Conduct require analysts to communicate the factors that were relevant in forming the conclusion, to distinguish fact from opinion, and to outline the scope and limitations of the analysis.
An investment decision is never final. A stock may be rejected for investment today because it is overvalued. However, if the value subsequently declines it would not necessarily merit investment. The decline in value may have resulted from deterioration in company fundamentals. It is usually necessary to update the analysis periodically, often repeating all of the steps in the process.