Chapter 1

Part A: Foundations and tools

Overview of financial statements analysis

Last updated November 20268 sectionsabout 7 min read

Key takeaways

Financial reporting is the company's responsibility to present its performance and position fairly; financial statement analysis is the user's job of applying judgement to that report to answer a specific decision question.
Under the IFRS Conceptual Framework, general purpose financial reporting gives existing and potential investors, lenders and other creditors information useful for decisions about providing resources to the entity.
The IASB sets IFRS, the framework Kenyan companies use, the FASB sets US GAAP, and national regulators such as the Capital Markets Authority decide which framework listed companies must apply.
Analysis runs in six steps: define the purpose and context, collect data, process it, analyse and interpret it, communicate the conclusions, then follow up with periodic review.
The audited statements and their notes are independently verified; management commentary and press reports are not, so weigh them accordingly.

Financial statements report what a company has already done; financial statement analysis is the discipline of extracting decision-useful meaning from that report, whether the decision is to invest, lend, or simply understand how the business is really performing.

Definition of financial statements analysis

Financial statement analysis is the process of examining a company's financial statements and related disclosures to evaluate its past and current financial performance and position, and to form a view on its likely future prospects, applying the analytical tools developed across this paper's later chapters.

Roles of reporting and analysis

Financial reporting

The company's own responsibility: preparing and communicating financial statements that fairly represent its performance, position and cash flows to those outside the business.

Financial statement analysis

The user's responsibility: applying analytical judgement and technique to that reported information to answer a specific decision question, an investor's buy/sell decision, a lender's credit decision, a regulator's oversight question.

Different reporting environment frameworks

International Accounting Standards Board (IASB)

Sets International Financial Reporting Standards (IFRS), the framework Kenyan companies, and this paper, are built around.

Financial Accounting Standards Board (FASB)

Sets US Generally Accepted Accounting Principles (US GAAP), the dominant alternative framework, materially converged with IFRS in many areas but still differing in specific rules an analyst comparing companies across the two frameworks must watch for.

Regulatory authorities

National bodies (in Kenya, the Capital Markets Authority, covered in CIFA Regulation of Financial Markets) that mandate which framework listed companies must use and enforce compliance with it.

Objective of financial statements

Per the IFRS Conceptual Framework, the objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity, the single standard every recognition, measurement and disclosure requirement in the next chapter ultimately serves.

Steps in analysing financial statements

Define the purpose and context of the analysis: what decision the analysis must support, and for whom
Collect data: the financial statements and the further sources listed below
Process the data: compute the ratios and other analytical measures relevant to the purpose (see the chapters on analytical tools and on analysing the statements)
Analyse and interpret the data: draw conclusions in the context of the industry, economy and company strategy
Communicate the conclusions and recommendations: typically a written report tailored to the intended user
Follow up with periodic review: revisiting the analysis as new information and financial statements become available

Change, globalism and technology

Importance: underpins investment, lending and management decisions that allocate real economic resources
Change: business models and transaction types evolve faster than accounting standards can always keep pace with, requiring analytical judgement beyond what a rule strictly requires
Globalism: companies increasingly operate, and raise capital, across borders and reporting frameworks, complicating comparability
Technology: growing data volume and analytical tools (see model building and forecasting, in the chapter on analytical tools) both expand what analysis can do and raise the bar for what counts as thorough analysis

Sources of information for analysis

The financial statements themselves

The statement of financial position, statement of comprehensive income, statement of cash flows and statement of changes in owners' equity, this guide's core subject matter, taken up in the chapters on reporting and on analysing the statements.

Notes to the financial statements

Disclose the accounting policies applied and the detail behind the summarised figures, frequently where the analytically important information actually lives.

Auditor's report

States whether the financial statements give a true and fair view, and flags any material uncertainty or qualification the analyst should weigh.

Management commentary

Management's own narrative discussion of performance, strategy and outlook, useful but, unlike the audited statements, not independently verified.

Supplementary information, sustainability and integrated reports

Additional voluntary or required disclosure, increasingly including climate and sustainability reporting (see the final chapter, on climate change).

Regulatory filings and press reports

Filings with the CMA (see CIFA Regulation of Financial Markets) and independent press coverage, both useful cross-checks against the company's own presentation of itself.

Approaches to analysing financial statements

Top-down approach

Starts from the macroeconomic environment, narrows to the industry, and finishes at the individual company, useful for understanding the broad forces shaping a company's results before examining the company itself.

Bottom-up approach

Starts directly from company-specific analysis, financial statements, competitive position, and builds outward to industry and macro context only as needed to interpret company-specific findings.

Exam tip

The five-source list above is a common recall question, remember that the audited financial statements and notes are verified, while management commentary and press reports are not, a distinction worth stating explicitly in any answer weighing source reliability.

Self-check

(a) Distinguish financial reporting from financial statement analysis. (2 marks)

(b) State the six steps in analysing financial statements, in order. (6 marks)

(d) State one source of information for analysis that is independently verified, and one that is not. (2 marks)

Show worked answer

(a) Financial reporting is the company's own responsibility, preparing and communicating financial statements that fairly represent its performance. Financial statement analysis is the user's responsibility, applying analytical judgement to that reported information to answer a specific decision question.

(b) 1. Define the purpose and context. 2. Collect data. 3. Process the data. 4. Analyse and interpret the data. 5. Communicate conclusions and recommendations. 6. Follow up with periodic review.

(c) The top-down approach starts from the macroeconomic environment, narrows to the industry, and finishes at the individual company. The bottom-up approach starts directly from company-specific analysis and builds outward to industry and macro context only as needed.

(d) Independently verified: the audited financial statements (or the notes to them). Not independently verified: management commentary (or press reports).