Financial Statement Analysis
Core concepts
Financial statement analysis builds a coherent picture from the balance sheet, income statement, and statement of cash flows. Candidates must know the structure of each statement, the articulation between them (retained earnings links net income to equity; ending cash on the cash flow statement must reconcile to the balance sheet), and the distinction between accrual accounting and cash movements. Understand revenue recognition, matching of expenses, depreciation methods, and the treatment of non-recurring items.
Traps to watch
- Timing mismatches: Revenue recorded before cash collection creates receivables; expenses accrued before payment create payables. Questions often test whether an item affects the income statement, the balance sheet, or both.
- Capitalizing vs. expensing: Capitalizing shifts cost to future periods and inflates current income.
- Classification: Operating vs. non-operating, and the difference between gross and net presentation.
- Sign conventions: Depreciation is added back on the cash flow statement but reduces net income.
Rule of thumb
When unsure how a transaction flows through the statements, trace it in three steps: (1) does it change net income? (2) does it change a balance sheet account? (3) does it change cash? A common worked example: a company records $10,000 of credit sales. Net income rises by the margin, receivables rise by $10,000, and operating cash flow is unaffected until collection. This three-step trace resolves most statement-linkage questions.