CFA Level 1 Financial Statement Analysis Notes: Income Statement, Balance Sheet, Cash Flow and Ratios

CFA financial statement analysis teaches you to read the three financial statements, the income statement, the balance sheet and the cash flow statement, and to judge a company with ratios. It carries an 11 to 14 percent weight in the 2026 CFA Level 1 exam, according to CFA Institute, which equals about 20 to 25 of the 180 questions, all tested in Session 1. The weight stays at 11 to 14 percent from February 2027. This note builds the statements from scratch, links them together and works two full examples. Start from the CFA notes hub.

CFA financial statement analysis: the three statements and how they link

Financial statement analysis turns three statements into one story: the income statement measures profit, the balance sheet shows what the company owns and owes, and the cash flow statement tracks real cash. Ratios then test liquidity, solvency and profitability, and DuPont splits return on equity into margin, turnover and leverage.

Every analysis starts from one equation: assets equal liabilities plus equity. The balance sheet is a snapshot at one date, so it must balance. The income statement and the cash flow statement cover a period, such as a year, and explain how the snapshot changed. Net income flows into retained earnings, and the cash flow statement explains the change in cash. Trace one number through all three statements and you understand the topic.

At Level 1, accounting questions default to IFRS, the international rules, unless a question says US GAAP. The frameworks agree on most of the structure, and the exam tests the few places where they differ, mostly in the cash flow statement. Learn IFRS first, then the US GAAP differences.

The income statement in CFA financial statement analysis

The income statement runs from revenue down to net income in a fixed order. Revenue minus cost of goods sold gives gross profit. Subtract operating expenses, such as selling, general and administrative costs and depreciation, to reach operating income, also called EBIT. Subtract interest and tax to reach net income. Gross margin and net margin are gross profit and net income divided by revenue.

Worked example 1: from revenue to retained earnings

Meridian Corp reports the following for the year ended December 31, 2025, in dollars. Revenue is 850,000 and cost of goods sold is 510,000, so gross profit is 340,000. Selling, general and administrative expense is 120,000 and depreciation is 40,000, so operating income is 180,000. Interest of 30,000 leaves earnings before tax of 150,000, and tax at 25 percent gives net income of 112,500.

Meridian Corp income statement, year ended Dec 31, 2025	Dollars
Revenue	850,000
Cost of goods sold	(510,000)
Gross profit	340,000
Selling, general and administrative expense	(120,000)
Depreciation	(40,000)
Operating income (EBIT)	180,000
Interest expense	(30,000)
Earnings before tax	150,000
Tax at 25%	(37,500)
Net income	112,500

Net income of 112,500 links straight to the balance sheet. Meridian pays dividends of 22,500, so 90,000 is added to retained earnings. Opening retained earnings are 210,000, so closing retained earnings are 300,000. Dividends never appear on the income statement; they reduce retained earnings directly, so a profitable company can still show falling equity if it pays out more than it earns.

The balance sheet in CFA financial statement analysis

The balance sheet lists what the company owns, what it owes and what is left for shareholders. Current assets, such as cash, receivables and inventory, convert to cash within a year, while non-current assets, such as property, plant and equipment, last longer. Current liabilities fall due within a year and long-term debt later. Equity is common stock plus retained earnings.

Meridian Corp balance sheet, Dec 31, 2025	Dollars
Cash	95,000
Accounts receivable	130,000
Inventory	175,000
Total current assets	400,000
Property, plant and equipment, net	600,000
Total assets	1,000,000
Accounts payable	110,000
Short-term debt	60,000
Accrued expenses	30,000
Total current liabilities	200,000
Long-term debt	300,000
Total liabilities	500,000
Common stock	200,000
Retained earnings	300,000
Total equity	500,000
Total liabilities and equity	1,000,000

The sheet balances: 1,000,000 of assets equal 500,000 of liabilities plus 500,000 of equity. Retained earnings of 300,000 match Worked Example 1. One year earlier, Meridian had assets of 900,000, liabilities of 490,000 and equity of 410,000, the opening figures the ratios below need.

CFA financial statement analysis and the cash flow statement

The cash flow statement splits cash movement into three buckets. Operating cash flow covers day-to-day trading: cash from customers, payments to suppliers and staff, interest and taxes. Investing cash flow covers buying and selling long-term assets, such as equipment. Financing cash flow covers raising and repaying capital: issuing shares or debt and paying dividends. A healthy company generates positive operating cash flow and uses it to fund investment and pay dividends.

The indirect method starts from net income, adds back non-cash charges such as depreciation, then adjusts for working capital. Higher receivables or inventory use cash, while higher payables save cash. The direct method lists cash receipts and payments instead, but both give the same operating cash flow. IFRS and US GAAP differ on where interest and dividends sit, as the table shows.

Cash flow item	IFRS	US GAAP
Interest received	Operating or investing	Operating
Interest paid	Operating or financing	Operating
Dividends received	Operating or investing	Operating
Dividends paid	Operating or financing	Financing
Income tax paid	Operating (generally)	Operating

Under US GAAP only dividends paid sit in financing, while IFRS lets the company choose for all four. Check the policy note before comparing operating cash flow across companies.

Ratio analysis at the heart of CFA financial statement analysis

Ratios judge liquidity, solvency, activity and profitability: whether the company can pay short-term bills, survive its debt, turn assets into sales, and earn on sales, assets and equity. Compare each ratio with last year, peers and the industry.

Ratios that mix an income statement flow with a balance sheet stock use average figures, because profit is earned across the year while the balance sheet is one date.

Worked example 2: liquidity, solvency and DuPont return on equity

Use the Meridian statements above: opening assets are 900,000 and opening equity are 410,000, so average assets are 950,000 and average equity are 455,000.

Ratio	Calculation	Result
Current ratio	400,000 / 200,000	2.00
Quick ratio	(95,000 + 130,000) / 200,000	1.13
Cash ratio	95,000 / 200,000	0.48
Debt-to-equity	500,000 / 500,000	1.00
Net profit margin	112,500 / 850,000	13.24%
Asset turnover	850,000 / 950,000	0.89
Return on assets	112,500 / 950,000	11.84%

Meridian covers current liabilities twice over, and 1.13 times without selling inventory, so short-term liquidity is comfortable. Debt-to-equity of 1.00 means creditors and shareholders fund the company equally. Now split return on equity with DuPont: margin times turnover times leverage, where leverage is average assets over average equity.

Financial leverage is 950,000 divided by 455,000, or 2.09. DuPont return on equity is 13.24 percent times 0.89 times 2.09, or 24.73 percent, and the direct calculation agrees: 112,500 divided by 455,000 is also 24.73 percent. The split tells the story: a solid margin, modest turnover and leverage of 2.09 lift return on assets of 11.84 percent to return on equity of 24.73 percent. For detail on inventory methods and write-downs, which change cost of goods sold and therefore every ratio above, see our CFA Level 1 inventory notes.

CFA financial statement analysis exam traps

• Net income is not cash. Strong profit can sit beside falling operating cash flow, because credit sales and non-cash charges sit between the two. Check cash flow first.
• The quick ratio excludes inventory. Using total current assets in the numerator gives the current ratio by mistake. Quick assets are cash, short-term marketable securities and receivables only.
• Debt-to-equity has two definitions. Some questions use total liabilities over equity, others use interest-bearing debt only. Read the question stem and use the definition it implies.
• IFRS and US GAAP classify interest and dividends differently. Under US GAAP, dividends paid are always financing; under IFRS they can be operating or financing. Use the framework the question names.
• DuPont uses average assets and average equity. Year-end figures give the wrong leverage and the wrong return on equity. Average the opening and closing balance sheets first.
• Dividends and share issues never touch the income statement. Dividends reduce retained earnings and issuing shares raises common stock. Both change the balance sheet only, so neither changes net income.

CFA financial statement analysis one-page revision box

Topic	Remember this
Weight	11 to 14 percent, about 20 to 25 of 180 questions, Session 1
Core equation	Assets = Liabilities + Equity; net income feeds retained earnings
Income statement	Revenue – COGS = gross profit; minus expenses = EBIT; minus interest, tax = net income
Balance sheet	Snapshot at a date; current items fall due within a year
Cash flow	Operating, investing, financing; indirect method starts from net income
IFRS vs US GAAP	US GAAP: only dividends paid are financing; IFRS allows a choice
Liquidity	Current = CA / CL; quick = (cash + securities + receivables) / CL; cash = cash / CL
Solvency	Debt-to-equity = debt / equity; check which definition of debt the question uses
DuPont	ROE = margin x turnover x leverage; use average assets and equity
Meridian answers	Net income 112,500; retained earnings 300,000; current 2.00; quick 1.13; ROE 24.73%

Work the two Meridian examples again from memory, then test yourself on the traps above. Financial statement analysis rewards candidates who link the statements instead of memorizing them in isolation, so practice tracing one number through all three statements until it feels automatic. Return to the CFA notes hub for the other Level 1 topics.