Reading a set of financial statements the way the CFA exam expects

A set of statements looks like a wall of numbers. The exam expects you to ask the same four questions of every one.

Why this topic carries so much

Financial Statement Analysis is 11 to 14 per cent of Level I in both the 2026 and 2027 outlines, and it feeds equities, corporate finance and fixed income. It covers reading income statements, balance sheets and cash flows, ratios and reporting choices.

It also rewards a habit rather than a flash of insight. If you read statements in the same order every time, the structure of questions becomes familiar and the arithmetic gets quicker.

Four questions for every set of statements

Ask these of every company, in this order.

1. Is the business profitable? Look at the income statement.
2. How is it financed and what does it own? Look at the balance sheet.
3. Do profits turn into cash? Look at the cash flow statement.
4. What changed, and why? Compare with last year and with peers.

Question four is where exam questions hide. A margin that fell, a receivable that grew faster than sales, a debt ratio that jumped. The change is the clue.

A worked example

Take a small company with these figures.

Income statement. Revenue 500. Cost of goods sold 300. Gross profit 200. Operating expenses 120. Operating profit (EBIT) 80. Interest 20. Profit before tax 60. Tax at 30 per cent, 18. Net income 42.

Balance sheet. Total assets 400. Shareholders' equity 200, so liabilities are 200.

Work through five measures.

Read them as a story. The company keeps 40 per cent of each sale after direct costs, keeps 8.4 per cent after everything, uses its assets 1.25 times a year and covers interest four times from operating profit. Return on equity is 21 per cent.

DuPont analysis

DuPont splits return on equity into three parts, so you can see where the return comes from.

ROE = net margin × asset turnover × financial leverage

Financial leverage here is total assets divided by equity.

• Net margin = 42 divided by 500 = 8.4 per cent
• Asset turnover = 500 divided by 400 = 1.25
• Financial leverage = 400 divided by 200 = 2.0

Multiply: 0.084 × 1.25 × 2.0 = 0.21, or 21 per cent, which matches the direct calculation.

Why bother? Because two companies can share the same ROE for different reasons. One may earn it through high margins, another through fast asset turnover, another through heavy borrowing. If the return comes mostly from leverage, it carries more risk. Exam questions often ask which of the three drove a change.

Reading the cash flow statement

Compare operating cash flow with net income. A healthy company converts profit into cash over time. If net income is rising but operating cash flow is flat or falling, ask why. Common reasons are growing receivables, building inventory or aggressive revenue recognition.

Also ask where cash goes: investing in growth, repaying debt, paying dividends or buying back shares. The pattern tells you the company's stage and its choices.

Traps in the exam

• Mixing periods. Use averages of opening and closing balances only when the question asks for them.
• Reading a ratio in isolation. One number means little without a comparison.
• Forgetting the definition. "Coverage" can use EBIT or EBITDA, so check the formula the question gives.
• Ignoring accounting choices. Inventory methods and depreciation policies change reported profit without changing cash.

How to study it

Pick one real company's annual report and work through it once with the four questions and the five measures. Then do timed questions by sub-topic. Allocate about 38 hours in a 300-hour Level I plan, according to the book's starting table, then move hours towards the sub-topics you rate lowest.

Keep a one-page sheet of the formulas you use, and rewrite it from memory every week. By the end of the plan, you should be able to produce it in five minutes.