Financial Statement Analysis. 24 question(s) in this unit's pool
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Question 1Exam level
A company has the following data: Net income = $120M, Revenue = $800M, Total assets = $600M, Total equity = $300M. Using the 3-factor DuPont decomposition, which of the following correctly identifies all three components and the resulting ROE, most likely?
How sure are you?
Correct: A. Net profit margin = 120/800 = 15%. Asset turnover = Revenue/Assets = 800/600 = 1.333x. Equity multiplier = Assets/Equity = 600/300 = 2.0x. ROE = 0.15 x 1.333 x 2.0 = 40%. Verify: ROE = NI/Equity = 120/300 = 40%. Choice B uses Revenue/Assets incorrectly as 600/800. Choice C uses NI/Assets (ROA calculation) and wrong leverage.
B. Choice B uses Revenue/Assets incorrectly as 600/800.
C. Choice C uses NI/Assets (ROA calculation) and wrong leverage.
Unit: financial-analysis-techniques
Question 2Exam level
Company A and Company B have identical ROEs of 18%. Company A achieved this with an equity multiplier of 1.2x and a net profit margin of 12%. Company B achieved it with an equity multiplier of 3.0x and a net profit margin of 4%. Which statement is most accurate?
How sure are you?
Correct: A. ROE quality is assessed by the SOURCE of ROE. Company A's high profit margin (12%) with low leverage (1.2x) means ROE is driven by genuine profitability. Company B must have a high asset turnover to compensate for the low margin, but the equity multiplier of 3.0x means substantial financial leverage is used. High leverage amplifies ROE but also amplifies risk. A downturn hits equity much harder at 3x leverage. The CFA exam considers leverage-driven ROE of lower quality than margin-driven ROE.
B. You might be tempted to think that a higher asset turnover indicates higher efficiency, but this overlooks the role of leverage in inflating ROE; Company B's higher equity multiplier suggests reliance on debt, which does not necessarily mean it is more efficient in asset utilization compared to Company A.
C. You might be tempted to think that identical ROEs mean equal quality, but this overlooks the critical distinction between leverage and profitability as drivers of ROE, where Company A’s ROE is driven by higher profitability rather than financial leverage, making its ROE quality superior.
Unit: financial-analysis-techniques
Question 3Harder
A company's ROE increased from 14% to 19% over one year. During the same period, net profit margin remained flat, asset turnover declined from 1.4x to 1.2x, and the financial leverage multiplier increased from 2.0x to 3.2x. An analyst should conclude that the ROE improvement is most likely:
How sure are you?
Correct: B. Decompose the change: margin was flat (neutral), asset turnover DECLINED (negative signal. Efficiency deteriorated), and leverage multiplier rose from 2.0x to 3.2x (60% increase. This drove all of the ROE improvement). The ROE increase is entirely leverage-driven. A company borrowing more to boost ROE while its operating efficiency deteriorates is a red flag. This is the classic 'ROE manipulation via leverage' scenario the CFA exam tests. Low-quality ROE improvement signals potential financial distress risk.
A. You might be tempted by the substantial increase in ROE, thinking a higher ROE always indicates high-quality performance, but this overlooks the critical role of financial leverage and operating efficiency, where increased leverage without improvement in operating metrics actually signals low-quality growth.
C. You might be tempted to think that an unchanged net profit margin indicates stability, leading to a neutral assessment, but this overlooks the significant decline in asset turnover and the substantial increase in financial leverage, which actually signal a low-quality ROE improvement.
Unit: financial-analysis-techniques
Question 4Exam level
Which of the following correctly describes the relationship between the 3-factor DuPont model and the 5-factor DuPont model, most likely?
How sure are you?
Correct: B. The 3-factor DuPont uses: (NI/Sales) x (Sales/Assets) x (Assets/Equity). The net profit margin (NI/Sales) can be algebraically split into three components: (NI/EBT) x (EBT/EBIT) x (EBIT/Sales). These are the tax burden, interest burden, and EBIT margin respectively. The 5-factor model therefore provides more diagnostic power. You can see whether a change in net margin came from tax management, interest expense changes, or operating profitability. Asset turnover and the equity multiplier remain identical in both models.
A. You might be tempted by the idea that the 5-factor model expands on the 3-factor model by adding distinct measures like return on assets and return on equity, but the 5-factor model actually refines the net profit margin into more granular components rather than introducing new ratios, thus choice A confuses the refinement of existing factors with the addition of new ones.
C. You might be tempted by the idea of using total debt for a more precise leverage measure, but the 5-factor model actually maintains the use of total assets in the asset turnover and equity multiplier components, focusing instead on breaking down the net profit margin into finer detail as the correct answer indicates.
Unit: financial-analysis-techniques
Question 5Exam level
Company X has ROE = 22%, ROA = 11%, and a debt-to-equity ratio of 1.0x. Which of the following correctly calculates the equity multiplier used in the DuPont framework? The value is closest to:
How sure are you?
Correct: B. The equity multiplier = Assets/Equity. Debt/Equity = 1.0x means Debt = Equity. Therefore Assets = Debt + Equity = 2 x Equity. Equity multiplier = Assets/Equity = 2.0x. Verify with DuPont: ROA x Equity multiplier = ROE. 11% x 2.0 = 22%. Check. The equity multiplier is also equal to 1 + Debt/Equity = 1 + 1.0 = 2.0x. This relationship (equity multiplier = 1 + D/E) is a frequently tested identity.
A. Choosing 1.0x might seem logical if you assume that assets equal equity, but this ignores the given debt-to-equity ratio of 1.0x, which indicates that assets are actually twice the equity, making the equity multiplier 2.0x, not 1.0x.
C. Choosing 0.5x might tempt you if you mistakenly calculate the equity multiplier as the inverse of the debt-to-equity ratio, but the equity multiplier is actually 1 plus the debt-to-equity ratio, making 0.5x incorrect and violating the correct formula of equity multiplier = 1 + D/E = 1 + 1.0 = 2.0x.
Unit: financial-analysis-techniques
Question 6Harder
A retail company has net income of $50M, revenue of $1,000M, total assets of $500M, and total equity of $250M. An analyst observes that a competitor in the same industry has net income of $80M, revenue of $800M, total assets of $800M, and total equity of $200M. Comparing the two companies using DuPont analysis, the first company most likely has:
How sure are you?
Correct: A. Company 1: NI/Sales = 5%, Sales/Assets = 2.0x, A/E = 2.0x. ROE = 5% x 2.0 x 2.0 = 20%. Company 2: NI/Sales = 10%, Sales/Assets = 1.0x, A/E = 4.0x. ROE = 10% x 1.0 x 4.0 = 40%. Company 2 has higher ROE (40% vs 20%). However, Company 1's leverage multiplier is 2.0x vs Company 2's 4.0x. Company 1's ROE is more quality-driven (higher asset turnover of 2.0x reflects operational efficiency in retail). Company 2's ROE is heavily leverage-dependent (4.0x multiplier). For a retail company where high asset turnover is normal, Company 1's profile is higher quality despite the lower ROE.
B. Choosing B might tempt you if you overlook the DuPont analysis components, leading you to focus solely on ROE without considering the quality of that ROE; while Company 1 has a lower ROE, its higher asset turnover and lower leverage indicate a higher quality ROE compared to Company 2, which relies more heavily on leverage.
C. Choosing C might tempt you if you assume that a higher leverage ratio automatically indicates higher quality, but this overlooks the importance of asset turnover in retail, where Company 1's higher asset turnover of 2.0x compared to Company 2's 1.0x demonstrates better operational efficiency and thus higher quality ROE.
Unit: financial-analysis-techniques
Question 7Exam level
In the 5-factor DuPont model, the interest burden ratio is most likely defined as:
How sure are you?
Correct: B. The interest burden = EBT/EBIT. This ratio measures how much of EBIT survives after paying interest expense. If interest expense is zero, EBT = EBIT and interest burden = 1.0 (maximum). As interest expense increases, EBT falls relative to EBIT and the interest burden ratio falls below 1.0, reducing ROE. A company with high interest expense will have a low interest burden ratio (e.g., 0.60 means 40% of operating profit is consumed by interest). This is NOT the interest coverage ratio (EBIT/interest expense).
A. You might be tempted by choice A because it seems to directly relate interest expense to the company's debt, but this ratio actually measures the interest expense per unit of debt rather than the impact of interest expense on earnings, which is what the interest burden ratio aims to capture by comparing EBT to EBIT.
C. Choosing net income divided by EBIT might seem logical if you are thinking about the overall profitability after all expenses, but this option confuses the interest burden with the overall profitability ratio, as the interest burden specifically measures the impact of interest expense on earnings before taxes, not the final net income.
Unit: financial-analysis-techniques
Question 8Exam level
A company's net profit margin increased from 8% to 10% year-over-year. Asset turnover remained constant at 1.5x. The equity multiplier fell from 3.0x to 2.0x. What happened to ROE, most likely?
How sure are you?
Correct: B. Year 1 ROE: 8% x 1.5 x 3.0 = 36%. Year 2 ROE: 10% x 1.5 x 2.0 = 30%. Despite the profit margin improvement (positive signal), ROE actually FELL because the company significantly reduced leverage (multiplier fell from 3.0x to 2.0x. A 33% decline). The leverage de-rating more than offset the margin gain. This scenario is important: ROE can fall even when margins improve if the company pays down debt or issues equity. The key insight for quality analysis: the ROE decline here is actually a POSITIVE quality signal. The company is less risky now.
A. You might be tempted to choose A because an increase in net profit margin typically suggests an improvement in profitability, but this overlooks the significant decrease in the equity multiplier, which actually reduces ROE more than the margin improvement increases it.
C. You might be tempted to choose C because it seems logical that an increase in net profit margin would lead to a higher ROE, but this overlooks the significant decrease in the equity multiplier, which actually reduces ROE from 36% to 30%, contrary to what choice C suggests.
Unit: financial-analysis-techniques
Question 9Exam level
Which of the following is the most accurate statement about the equity multiplier in the DuPont framework?
How sure are you?
Correct: B. The equity multiplier = Total Assets / Total Shareholders' Equity. It measures how many dollars of assets the company controls per dollar of equity. A direct measure of financial leverage. An equity multiplier of 3.0x means the company has $3 of assets for every $1 of equity, implying $2 of debt per $1 of equity (D/E = 2.0x). The equity multiplier is NOT equivalent to D/E. It equals 1 + D/E. A higher equity multiplier boosts ROE arithmetically but also amplifies risk. Higher leverage means more volatile earnings and greater probability of financial distress.
A. You might be tempted to think that higher leverage always improves financial performance, but a higher equity multiplier actually indicates greater financial risk and does not guarantee better performance, as it only measures financial leverage and not profitability or efficiency.
C. You might be tempted to choose C because both the equity multiplier and the debt-to-equity ratio involve measuring leverage, but the equity multiplier actually equals total assets divided by total shareholders' equity, which is not the same as the debt-to-equity ratio, as it includes both debt and equity in its calculation.
Unit: financial-analysis-techniques
Question 10Exam level
An analyst notes that Firm Alpha's ROE improved from 15% to 21% over two years, while ROA remained nearly flat at 7%. Which of the following is the most likely explanation?
How sure are you?
Correct: B. ROE = ROA x Equity multiplier. If ROA is flat at 7% but ROE increased from 15% to 21%, the only DuPont factor that could drive this change is the equity multiplier (financial leverage). Year 1: 15% = 7% x 2.14x. Year 2: 21% = 7% x 3.0x. The equity multiplier increased from approximately 2.1x to 3.0x. The company took on more debt or bought back equity. Operational efficiency (ROA = NI/Assets) did not change. Tax changes affect ROA directly, so if ROA is flat, tax burden changes did not drive the ROE improvement.
A. You might be tempted to think that improved operational efficiency directly boosted ROE, but remember that ROA, which reflects operational efficiency, remained flat at 7%, indicating that operational improvements did not drive the ROE increase.
C. You might be tempted to think that a decrease in the tax rate could boost ROE without affecting ROA, but remember that a lower tax rate would increase net income and thus ROA, contradicting the flat ROA observed. Financial leverage, not tax rate changes, is the factor that can increase ROE while keeping ROA constant.
Unit: financial-analysis-techniques
Question 11Exam level
In the 5-factor DuPont decomposition, the tax burden ratio equals 0.65. This means that, most likely:
How sure are you?
Correct: B. Tax burden = NI/EBT = 1 - effective tax rate. If tax burden = 0.65, then effective tax rate = 1 - 0.65 = 35%. For every $1 of pre-tax income (EBT), the company retains $0.65 after paying $0.35 in taxes. Note the counter-intuitive direction: a LOWER tax burden ratio = HIGHER effective tax rate. A tax burden of 0.65 is not the same as saying 'tax rate is 65%'. That would be an abnormally high corporate tax rate. The tax burden ratio is the fraction of EBT retained, not the fraction paid.
A. You might be misled into thinking the tax burden ratio directly reflects the tax rate, but the tax burden ratio actually shows the fraction of pre-tax income retained after taxes, not the tax rate itself. A tax burden of 0.65 indicates the company retains 65% of its pre-tax income, implying an effective tax rate of 35%, not a tax rate of 65%.
C. You might be tempted to think that a tax burden ratio of 0.65 directly translates to the tax paid, but the tax burden ratio actually reflects the fraction of pre-tax income retained after taxes, not the tax paid; thus, a ratio of 0.65 means the company retains 65 cents of every pre-tax dollar, implying an effective tax rate of 35%, not that 65 cents of every EBIT dollar is paid in taxes.
Unit: financial-analysis-techniques
Question 12Exam level
An analyst calculates the following for a company: Net income = $120M; Revenue = $800M; Total assets (beginning of year) = $900M; Total assets (end of year) = $1,100M; Total equity = $600M. What is the company's return on assets (ROA), most likely?
How sure are you?
Correct: A. The correct answer is 12.0%. ROA = Net Income / Average Total Assets = $120M / (($900M + $1,100M)/2) = $120M / $1,000M = 12.0%..
B. End-of-period balance sheet figure is given most recently and feels like the 'right' number. CFA curriculum requires average total assets for ROA denominator. Average smooths out asset changes during the year.
C. Some ratio definitions in other textbooks use beginning-period assets. CFA uses average; using beginning-year assets is nonstandard for this exam.
Unit: financial-analysis-techniques
Question 13Exam level
A company reports: Current assets = $500K; Inventory = $180K; Prepaid expenses = $20K; Current liabilities = $250K. What is most likely the quick ratio?
How sure are you?
Correct: A. The correct answer is 1.20. Quick ratio = (Cash + Short-term securities + Receivables) / Current Liabilities = (Current Assets - Inventory - Prepaid expenses) / Current Liabilities = ($500K - $180K - $20K) / $250K = $300K / $250K = 1.20..
B. You might confuse current ratio with quick ratio when both figures are available. Quick ratio excludes inventory AND prepaid expenses (less-liquid current assets).
C. You might know to remove inventory but forget prepaid expenses also must be excluded. CFA curriculum: quick ratio excludes all non-liquid current assets including prepaid expenses.
Unit: financial-analysis-techniques
Question 14Exam level
Company A has ROE of 18%. Decomposing via DuPont: Net profit margin = 6%; Asset turnover = 1.5x. What is the company's financial leverage multiplier (equity multiplier), most likely?
How sure are you?
Correct: A. The correct answer is 2.0x. DuPont: ROE = Net Profit Margin x Asset Turnover x Equity Multiplier. 18% = 6% x 1.5 x Equity Multiplier. Equity Multiplier = 18% / (6% x 1.5) = 18% / 9% = 2.0x..
B. You might conflate asset turnover with equity multiplier. Asset turnover (1.5x) is already given. Equity multiplier is the third DuPont component.
C. Forgetting to incorporate net profit margin into the denominator. All three components multiply together: ROE = margin x turnover x leverage.
Unit: financial-analysis-techniques
Question 15Harder
Which of the following would most likely indicate deteriorating liquidity even if the current ratio remains unchanged?
How sure are you?
Correct: A. The correct answer is An increase in the proportion of inventory within current assets. If current ratio stays the same but more of current assets are now inventory (least liquid), the quality of liquidity has deteriorated. The quick ratio would fall..
B. More assets seems better. If current liabilities increased proportionally, the current ratio is unchanged and we have no information about composition.
C. More debt seems bad. If both current liabilities and cash increase by the same amount, the current ratio changes but the composition of assets (more cash) actually improves liquidity quality.
Unit: financial-analysis-techniques
Question 16Exam level
A firm's debt-to-equity ratio is 0.8. Total equity is $500M. What is most likely the total debt?
How sure are you?
Correct: A. The correct answer is $400M. D/E = Total Debt / Total Equity. 0.8 = Total Debt / $500M. Total Debt = 0.8 x $500M = $400M..
B. You might confuse D/E with D/Capital (debt-to-capital ratio). D/E = Debt/Equity. D/(D+E) is debt-to-capital. These are different ratios with different denominators.
C. Algebraic inversion error under exam pressure. D/E = 0.8 means debt is 80% of equity, not equity is 80% of debt.
Unit: financial-analysis-techniques
Question 17Exam level
Company X has EBIT of $80M and interest expense of $20M. Company Y has EBIT of $150M and interest expense of $60M. Which company most likely has greater ability to service its debt from operations?
How sure are you?
Correct: A. The correct answer is Company X. Interest coverage ratio = EBIT / Interest Expense. Company X = $80M / $20M = 4.0x. Company Y = $150M / $60M = 2.5x. Company X can cover interest 4x vs. 2.5x for Company Y. Higher = better debt servicing ability..
B. Larger absolute EBIT looks stronger. The ratio must be used, not the absolute value. Company Y has proportionally far more debt.
C. You might think solvency requires balance sheet data. Interest coverage is an income-statement-only ratio. Balance sheet not needed.
Unit: financial-analysis-techniques
Question 18Exam level
A company's inventory turnover increased from 4x to 6x year-over-year while its days inventory outstanding (DIO) decreased from 91 days to 61 days. Which statement is most accurate?
How sure are you?
Correct: A. The correct answer is The company is managing inventory more efficiently: it is selling and replenishing inventory faster, which reduces storage costs and obsolescence risk. DIO and turnover always move inversely (DIO = 365/turnover)..
B. Lower inventory days could mean running out of stock. Without additional context, higher turnover is the default positive interpretation for efficiency. Shortages would also show in revenue decline, not turnover increase.
C. You might see one ratio go up and one go down and misread it as contradiction. These ratios are mathematical inverses. They cannot conflict. They are the same metric expressed differently.
Unit: financial-analysis-techniques
Question 19Harder
Under IFRS, a company capitalizes development costs as an intangible asset. A US GAAP competitor expenses all R&D immediately. All else equal, which company will most likely report higher asset turnover in the first year of the project?
How sure are you?
Correct: A. The correct answer is The US GAAP company. Because it expenses R&D immediately, its total assets are lower (no capitalized intangible). Lower assets with same revenue = higher asset turnover. Asset turnover = Revenue / Average Total Assets..
B. More assets seems like a stronger company with more productive base. More assets with the same revenue means LOWER asset turnover (less efficient use of assets).
C. Same revenue suggests same numerator, so same ratio. Revenue is the same but the denominator (total assets) differs. GAAP company has fewer assets, so its asset turnover is higher.
Unit: financial-analysis-techniques
Question 20Exam level
An analyst observes a company's ROE rose from 12% to 18% over two years. Net profit margin declined from 8% to 5% and asset turnover declined from 1.5x to 1.4x. What is the most likely explanation?
How sure are you?
Correct: A. The correct answer is The company increased financial leverage significantly. Using DuPont: ROE = Margin x Turnover x Leverage. Year 1: 12% = 8% x 1.5 x L1, then L1 = 1.0x. Year 2: 18% = 5% x 1.4 x L2, then L2 = 18% / 7% = 2.57x. Leverage more than doubled while profitability and efficiency both declined..
B. ROE increased, so operations must have improved. Both profit margin and asset turnover declined. Operational performance worsened.
C. Companies grow ROE through revenue growth. Asset turnover declined, meaning revenue growth lagged asset growth. Margin also fell.
Unit: financial-analysis-techniques
Question 21Harder
Which ratio is most useful for comparing the financial leverage of two companies that use different accounting methods for operating leases, most likely?
How sure are you?
Correct: A. The correct answer is Debt-to-EBITDA (or adjusted leverage ratios). IFRS 16 requires all leases on balance sheet; older US GAAP allowed operating lease off-balance-sheet treatment. Adjusting by using EBITDA (which adds back non-cash charges) and using a consistent debt definition makes comparisons more valid..
B. Standard textbook solvency ratio. As-reported D/E is not comparable across firms with different lease accounting. Off-balance-sheet leases understate both debt and assets.
C. Interest coverage is a solvency measure. Interest coverage uses income statement only and does not capture balance sheet leverage differences from lease capitalization.
Unit: financial-analysis-techniques
Question 22Exam level
A company has net sales of $1,200M, COGS of $720M, and average total assets of $800M. What are the gross profit margin and asset turnover respectively, most likely?
B. COGS/Revenue gives 60%, which some confuse with gross margin. COGS/Revenue is the cost ratio, not gross margin. Gross margin = gross profit / revenue = (revenue - COGS)/revenue.
C. Inverting the asset turnover formula under time pressure. Asset turnover = Revenue / Assets, not Assets / Revenue.
Unit: financial-analysis-techniques
Question 23Above the exam
Company A has net profit margin of 8%, asset turnover of 1.2x, and a financial leverage multiplier of 2.0x. Company B has net profit margin of 10%, asset turnover of 1.0x, and a financial leverage multiplier of 1.8x. Combining the 3-factor DuPont decomposition with a comparison of the two companies, which is most likely true?
How sure are you?
Correct: A. ROE = Net profit margin x Asset turnover x Financial leverage. Company A: 8% x 1.2 x 2.0 = 19.2%. Company B: 10% x 1.0 x 1.8 = 18.0%. Despite Company B having the higher profit margin in isolation, Company A's combination of all three DuPont drivers together produces a higher overall ROE; the full decomposition, not any single component alone, determines the outcome.
B. Having the higher profit margin alone does not guarantee the higher ROE; ROE depends on the PRODUCT of all three DuPont components together. Company A's advantage in asset turnover and leverage more than offsets Company B's margin advantage once all three factors are multiplied together.
C. There is no rule that DuPont components must offset exactly between two different companies; each company's ROE is simply the product of its own three ratios, and there is no reason two companies with different underlying ratios would coincidentally arrive at the same ROE.
Unit: financial-analysis-techniques
Question 24Above the exam
An analyst compares two companies in different countries using the current ratio and quick ratio. Company X has a current ratio of 2.5 and a quick ratio of 0.8. Company Y has a current ratio of 1.6 and a quick ratio of 1.4. Combining what the gap between the two ratios reveals with the composition of current assets, the analyst should most likely conclude that:
How sure are you?
Correct: B. The quick ratio excludes inventory (and other less-liquid current assets) from the numerator, while the current ratio includes them. A large GAP between a company's current and quick ratio (Company X: 2.5 vs 0.8, a gap of 1.7) indicates that a large share of its current assets is tied up in inventory or similar illiquid items. Company Y's much smaller gap (1.6 vs 1.4) indicates its current assets are mostly readily liquid already, a qualitatively different, and often more reassuring, liquidity picture even with a lower headline current ratio.
A. A higher current ratio alone does not necessarily mean stronger REAL liquidity if much of that ratio is driven by inventory that may be slow or difficult to convert to cash; comparing the current and quick ratios together, rather than the current ratio in isolation, is exactly what reveals this nuance.
C. The two companies' liquidity profiles are clearly different once both ratios are examined together: Company X relies heavily on less-liquid current assets to reach its current ratio, while Company Y's current assets are almost entirely already liquid; treating 'current ratio' and 'quick ratio' as interchangeable misses the entire point of comparing them.