CFA Exam – What is it? Why do it? How to prepare

IT would be easy to forget that there are many fine people out there who have never heard of this “CFA Program”.

What is the CFA Program?

The CFA Institute describes the CFA Program as a graduate-level course for investment professionals. The course covers an extremely broad range of topics including:

  • ethics,
  • quantitative methods (read: basic statistics/econometrics),
  • economics,
  • financial statement analysis,
  • corporate finance,
  • portfolio management,
  • equity investments,
  • fixed income investments,
  • derivatives, and
  • alternative investments.

Why become a CFA Charterholder?

If you are a practicing or aspiring consultant, is it worth becoming a CFA Charterholder? In my opinion, CFA Level 1 is definitely worth doing as it provides a very good overview of economics, finance and asset management which will help you understand how a company should manage its assets. If you want to be able to provide a company with comprehensive advice, it is useful (if not essential) to understand how to value a business, deal with its assets, identify appropriate investment opportunities, manage cash flows, and obtain financing.

Preparing for the CFA Exam

Having just completed the exam, I thought it would be useful to provide some thoughts on how to prepare for the CFA Level 1 exam. However, I realise that this job has already been done.

James Cox provides a concise and easy to follow study plan for passing the CFA level one exam. If you are a CFA candidate, or considering becoming a CFA candidate, it is well worth reading.

CFA Level 1 Exam 2009 – post audit

An exam day overview

I did the CFA Level 1 Exam yesterday. If you haven’t heard of the CFA Exam before, see the article “CFA Exam – What is it? Why do it? How to prepare.”

It is definitely one of the most exhausting tests I have undertaken, a gruelling six hour 240 question multiple choice exam. The CFA Institute recommends 250 hours of study for the test, and I only managed to notch up about 120 hours at best. Needless to say, I found it to be quite a tough exam.

If the pass mark for the exam were a simple 50%, I would be confident about passing. Each multiple choice question had three possible answers, so the expected result from blind guessing is a healthy 33%. A bit of common sense, some clever educated guessing, and my background in economics and econometrics would probably be enough to push me above the 50% mark.

Unfortunately, the pass mark for the exam is somewhere around 70%. So, success is by no means assured.

The examination supervisors are called “proctors” and, as I sat down in the exam hall, the head proctor’s voice boomed over the audio system, “All electronic devices, including mobile phones, must be switched off and surrendered. We have systems in place to detect the use of any electronic device within the examination hall. If a mobile phone is discovered in your possession during the timed portion of the examination, it will be confiscated and a written report will be submitted to the CFA Institute”.  Wow, the power had really gone to his head. We were under the control of a 60-something year old power hungry proctor.

As it turned out, the Salvation Army were holding their National Congress right next to the examination hall . Trumpets, trumbones, drumming, and a chorus of voices filled the exam hall for the entire first half of the exam. Did God not know I was trying to concentrate? I can only hope that this highly inopportune spiritual distraction was a positive omen.

Thirty minutes into the test, the choir continued to sing, and I read my first economics question: “If the supply of money decreases which of the following is least likely to result in an increase to  …” Decrease, least likely, increase … sorry?

Some kind of miracle may be required.

Understanding financial statements 101

UNDERSTANDING financial statements is very important if you are looking to invest, become a consultant, work as a CEO or in upper management, or want to start and run your own business. Understanding financial statements will allow you to assess a company’s current financial strength, and determine its profitability and creditworthiness. This article provides an overview of the four key financial statements that you need to understand.

There are four basic financial statements that you need to understand in order to evaluate a company, including the:

  1. Balance Sheet;
  2. Profit and Loss Statement;
  3. Cashflow Statement; and
  4. Statement of Retained Earnings (Owner’s Equity).

1. Balance Sheet

The Balance Sheet presents the financial position of a company at a given point in time. It is made up of three parts: Assets, Liabilities and Equity.

Assets are the economic resources that a company uses to operate its business: e.g. cash, inventories, and equipment.

Liabilities represent the debts of the company, the claims that creditors have on the company’s resources.

Equity represents the net worth of a company, and equals Assets minus Liabilities. Equity holders are the owners of the business.

It is important to notice that Equity is defined as a residual amount. As a rule, companies do not promise to pay back Equity holders. An Equity holder’s investment is more risky than a loan given by a bank because their investment is not guaranteed. In the event of insolvency, bank loans and other debts are repaid before Equity; Equity holders receive the residual amount after all the debts of the company have been paid.

2. Profit and Loss Statement

The Profit and Loss Statement measures the success of a company’s operations; it provides investors and creditors with information to determine the profitability and creditworthiness of the enterprise.

The Profit and Loss Statement presents the results of operations of a business over a specified period of time (e.g. one year, one quarter, one month); it is comprised of Revenues, Expenses, and Net Profit (Loss).

Revenue is the income that is generated from trading, i.e. when the company sells goods or services. Although, it might also come from other sources, for example, selling off a piece of the business or a piece of equipment. It is important to note that, revenue is recorded when the sale is made as opposed to when the cash is received.

Expenses are the costs incurred by a business over a specified period of time to generate the revenues earned during the same period. It is important to distinguish Assets from Expenses. A purchase is considered an asset if it provides future economic benefit to the company, while expenses only relate to the current period. For example, monthly salaries paid to employees for services that have already been provided are expenses. On the other hand, the purchase of a piece of manufacturing equipment would normally be classified as an asset.

Net Profit (Loss) is equal to the revenue a company earns minus its expenses during a specified period of time.

3. Cashflow Statement

The Profit and Loss Statement does not provide information about the actual receipt and use of cash generated during a company’s operations.

The Cashflow Statement presents a detailed summary of all of the cash inflows and outflows over a specified period of time; it is divided into three sections based on three types of activity:

1. Cash flows from operating activities: includes the cash effects of transactions involved in calculating net profit (loss).

2. Cash flows from investing activities: involves items classified as assets in the Balance Sheet; it includes the purchase and sale of equipment and investments.

3. Cash flows from financing activities: involves items classified as liabilities and equity in the Balance Sheet; it includes the payment of dividends as well as the issuing and payment of debt or equity.

4. Statement of Retained Earnings (Owner’s Equity)

The Statement of Retained Earnings shows the retained earnings at the beginning and end of the accounting period. It breaks down changes affecting retained earnings such as profits or losses from operations, dividends paid, and any other items charged or credited to retained earnings.

The Statement of Retained Earnings uses the net income information from the Profit and Loss Statement and provides information to the Balance Sheet. Retained earnings are part of the Balance Sheet under Owner’s Equity.

The general equation for calculating Retained Earnings can be expressed as following:

Retained Earnings (year end) = Retained Earnings (beginning of the year) + Net Income – Dividends Paid

What is an asset? What does it mean to be wealthy?

What is an asset?

THE question, “What is an asset?” seems like an absurdly simple question. But if you understand the answer to that simple question, and act on it, you have started down the path that leads to riches. Few people become rich, so clearly then, few people understand the answer to this question. Let’s have a closer look.

The Oxford English Dictionarydefines an asset as “a useful or valuable thing or person; [or as] property owned by a person or company.” This is the strict dictionary definition of the word ‘asset’. However, if I use this definition of ‘asset’ when deciding how to spend my money then I am likely to make mistakes. That is, I am likely to make decisions that I would not have made had I really understood what an asset is.

Using the Oxford dictionary definition of ‘asset’, I could be mistaken for thinking that my Mercedes that I have parked out the front is an asset. I own it, it is very useful and it is definitely valuable. This satisfies the dictionary definition of an asset. In addition, the bank will usually be willing to count my Mercedes as an asset when I ask for a personal loan.

In Rich Dad Poor Dad, Robert Kiyosaki makes the insightful point that, “what defines an asset is not words but numbers”. Let’s consider the numbers relating to my Mercedes. Every month I have a series of expenses that I incur because I own my Mercedes. My expenses might include: fuel $400, on-road maintenance costs $50, and insurance $200. So, every month my Mercedes costs me $650 in expenses. This doesn’t sound much like an asset.

According to Robert Kiyosaki, an asset is “something that puts money in my pocket every month.” By this definition, my Mercedes is not an asset but a liability. It costs me $650 each and every month, and that’s not including depreciation.

But, what about my house, is that an asset? The conventional wisdom is that you’re house is an asset, and the bank will certainly let you count it as an asset when you ask to borrow money. Let’s apply Kiyosaki’s definition to see whether a house is an asset. Every month you might have to pay: property taxes $200, loans $3000, utilities $200, and maintenance $100. In this example, your house costs you $3,500 each and every month. This doesn’t sound much like an asset.

It is true that, unlike my Mercedes, houses usually appreciate in value. However, there are three problems with this:

  1. Property does not always appreciate in value. The recent sub-prime mortgage crisis in the United States has taught us all that lesson, if we didn’t know it already;
  2. Tying up all of your money in your house comes at a high opportunity cost. So, while the value of your house may be rising and you are managing to pay off your mortgage, you may be unable to take advantage of great opportunities that are presented to you. “I would, but I have to make mortgage payments”;
  3. Your home does not put money in your pocket every month. The only time that you can obtain money from your house is when you sell it. For one reason or another, people are often reluctant to sell their homes. This fact remains true even when people are in tight financial circumstances.

The kind of assets that I’m talking about come in various forms, five examples include:

  1. Businesses that do not require your presence. If you need to be there to run the business it is a job and not a business;
  2. Stocks;
  3. Bonds;
  4. Income-generating real estate; and
  5. Royalties from intellectual property such as books or music.

Once you understand the difference between assets and liabilities, it is a good idea to concentrate your efforts on only buying income-generating assets. This is the path to wealth and riches.

What does it mean to be wealthy?

If the main game is to become wealthy, it would pay to stop for a second and consider what it would mean to be wealthy.

I am inclined to accept the definition of wealth that Kiyosaki puts forward, borrowed from Buckminster Fuller.

Wealth is a person’s ability to survive so many number of days forward into the future if they were to stop working today. So, I have become wealthy when my income each month, which is generated from my assets, fully covers my monthly expenses. If I want to increase my monthly expenses, I must increase my cash flow obtained from my assets in order to maintain my wealth.

To say that someone is wealthy, then, is to say nothing about whether that person is rich. I can be wealthy without being rich.

How much income do I need each month, generated from my assets, before I can consider myself rich? The answer to that question is up to you. The definition of ‘rich’ is in the eye of the beholder.