Financial Analysis Techniques

Financial Statement Analysis. Worth 11 to 14 percent of the exam. One session: the lesson, the rules, the method, then the questions.

Financial Statement AnalysisFinancial Analysis Techniques
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The lesson

Runtime 16 minutes 6 seconds, measured from the published video.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to work the standard ratio families, activity, liquidity, solvency and profitability, describe how ratios in different families read together rather than alone, demonstrate DuPont's split of ROE and say what actually moved each factor, and recognize when an industry-specific measure captures a business better than a generic ratio does.

A ratio is a diagnostic tool, never a verdict on its own. It only means something once compared against a benchmark: the company's own history, a peer, or a plan. The single most repeated mechanical error across this entire module has nothing to do with which ratio to use and everything to do with the denominator: whenever a problem supplies both a beginning and an ending balance sheet figure, average them before dividing. Return on assets, return on equity, asset turnover, inventory turnover and receivables turnover all compare a full-period flow figure, net income or revenue, against a point-in-time balance sheet figure, and using only the ending balance mismatches a whole year of activity against a single day's snapshot.

Activity ratios match their numerator to how the related asset is actually valued. Inventory turnover uses cost of goods sold in the numerator, because inventory sits on the books at cost. Receivables turnover uses revenue instead, because a receivable represents an unpaid sale recorded at the price it sold for, not at cost. Applying cost of goods sold where revenue belongs, or the reverse, is the most common cross-ratio mixing error.

DuPont decomposition breaks return on equity into three multiplied factors: net profit margin, how much of each revenue dollar survives as profit; asset turnover, how efficiently assets generate revenue; and the equity multiplier, how much leverage amplifies the return equity earns. The equity multiplier equals average total assets over average equity, which is mathematically equal to one plus the debt-to-equity ratio, never the debt-to-equity ratio itself: a debt-to-equity of 1.0 gives an equity multiplier of 2.0, not 1.0. When ROE changes, recompute all three factors rather than assuming the headline direction reflects an operating improvement. An ROE increase driven mostly by a rising equity multiplier, with margin and turnover flat or falling, is leverage doing the work, not the business getting better, and it carries more risk, not less, even though the headline number looks stronger.

No single ratio tells the whole story, and reading across categories catches what one ratio alone would miss. A stable current ratio can hide a shift toward less liquid current assets that only a falling quick ratio would reveal. A comfortable interest coverage ratio says nothing about balance-sheet leverage by itself. A rising ROE, as the DuPont breakdown above shows, can hide deteriorating margins and efficiency entirely.

Some businesses need their own ratios because the generic ones do not capture what actually drives them. A retailer is read through same-store sales growth and inventory turnover; a bank through net interest margin and capital adequacy; an airline through load factor and cost per available seat mile. Recognizing when a sector-specific measure explains a business better than a generic profitability or activity ratio is itself part of the analysis, not a separate skill.

DuPont decomposition of ROE into three drivers ROE Net profit margin Asset turnover Financial leverage how profitable, x how efficient, x how levered
ROE splits into three multiplied drivers: how much profit each sales dollar keeps, how many sales dollars each asset dollar produces, and how many asset dollars each equity dollar carries.

Worked in full

A company reports net income of $45 million, revenue of $900 million, average total assets of $500 million, and average shareholders' equity of $150 million. Decompose ROE using the three-factor DuPont formula. Net profit margin = $45M / $900M = 5.0%. Asset turnover = $900M / $500M = 1.8x. Equity multiplier = $500M / $150M = 3.33x. ROE = 5.0% x 1.8 x 3.33 = 30.0%. Check: ROE should also equal net income / average equity = $45M / $150M = 30.0%, confirming the decomposition.

The same problem, one step removed

Same figures: net income $45 million, revenue $900 million, average total assets $500 million, average equity $150 million. Compute net profit margin and asset turnover yourself, then finish the equity multiplier and the full ROE.

The trap

A rising ROE with flat net profit margin and falling asset turnover is not an operating improvement; the equity multiplier is the only component left that can explain the rise, which means leverage, not profitability or efficiency, produced the better-looking number.

What this unit turns on

Read these before the questions, not after them. Everything here traces to this module's own lesson and to the 2026 outline.

A ratio is a diagnostic tool with a specific use and a specific blind spot, never a verdict on its own

Ratio analysis lets an analyst compare a company across time, against peers, and against its own plan, but every ratio is a simplification: it can be distorted by accounting choices (inventory method, lease treatment, capitalization policy), by one-time items, and by the specific point-in-time or period-length convention used to build it. A ratio's value only means something once compared to a benchmark, trend, or peer; a single ratio in isolation answers no question by itself.

Balance-sheet-based ratio denominators use the average of beginning and ending balances

Return on assets, return on equity, asset turnover, inventory turnover, and receivables turnover all divide by an average balance-sheet figure, beginning plus ending divided by two, whenever both dates are available, because the income-statement numerator (net income or revenue) is a full-period flow being compared against a point-in-time stock; using only the ending balance mismatches a full-year flow against a single day's snapshot.

Inventory-related ratios use cost; receivables-related ratios use revenue

Inventory turnover and days inventory outstanding use cost of goods sold in the numerator because inventory itself sits on the books at cost. Receivables turnover and days sales outstanding use revenue because a receivable represents an unpaid sale recorded at the selling price, not at cost. Applying COGS where revenue belongs, or the reverse, is the most common cross-ratio mixing error.

Ratios from different categories should be read together, not in isolation

A stable current ratio can mask a shift toward less-liquid current assets that only a falling quick ratio would reveal; a rising ROE can mask deteriorating profitability and efficiency that only DuPont decomposition would expose; a comfortable interest coverage ratio says nothing about balance-sheet leverage on its own. Evaluating a company well means reading liquidity, solvency, profitability, and activity ratios together and checking whether they tell a consistent story.

DuPont decomposes ROE into margin, turnover, and leverage, and the exam tests reading, not just computing, the split

ROE = net profit margin x asset turnover x equity multiplier, where the equity multiplier (average total assets over average equity) equals one plus the debt-to-equity ratio. When ROE changes, recompute all three components rather than assuming the headline direction reflects operating improvement; an ROE increase driven mostly or entirely by a rising equity multiplier, with flat or falling margin and turnover, is a leverage-driven, lower-quality increase, not a sign the business is running better.

Some industries need their own ratios because standard ones do not capture what actually drives the business

A retailer is often read through same-store sales growth and inventory turnover, a bank through net interest margin and capital-adequacy measures, an airline through load factor and cost per available seat mile, none of which map onto the generic profitability or activity ratios built for a manufacturer; recognizing when an industry-specific measure is more informative than a generic one is itself a tested analytical judgment.

Historical ratio trends and relationships are a starting point for forecasting, not a guarantee

Projecting a company's future margins, turnover, or growth from its historical ratio trend is a standard first step in building a forecast, but it assumes the underlying business relationships (cost structure, competitive position, capital intensity) continue to hold; a forecast built purely by extrapolating past ratios ignores changes in strategy, competition, or the economic cycle that could break the pattern.

The trick

Two balance sheet dates in the data means average, always

Whenever a problem supplies both a beginning and an ending balance sheet figure, that is the signal to average them for any ratio's denominator; using only the ending figure is the single most repeated calculation error across this whole topic.

Quick ratio subtracts inventory AND prepaid expenses

Prepaid expenses are just as illiquid as inventory for the quick ratio's purpose; leaving them in overstates the ratio.

COGS goes with inventory; revenue goes with receivables

Both assets are activity-ratio denominators built from the numerator that matches how the asset itself is valued: inventory at cost, receivables at the sale price.

Equity multiplier equals 1 + D/E, never D/E itself

A debt-to-equity ratio of 1.0 gives an equity multiplier of 2.0, not 1.0; confusing the two produces an ROE calculation off by a predictable, testable margin.

The method

The order to work a question of this type in, every time, before you touch the numbers.

  1. Check whether the question supplies beginning and ending balance sheet figures; if so, average them before computing any ratio that uses them.
  2. Match numerator to denominator by valuation basis: cost-based numerators (COGS) with cost-based assets (inventory); revenue-based numerators with sale-price assets (receivables).
  3. When ROE, or any composite metric, changes, decompose it into its full set of drivers rather than reading the headline direction alone.
  4. Cross-check a ratio's story against ratios from other categories (liquidity against activity, profitability against leverage) before concluding a company's position has improved or worsened.
  5. For an industry-specific scenario, ask whether a generic ratio actually captures the economics of that business, or whether a sector-specific measure would be more informative.

The practice run

Pick an answer, say how sure you are, then reveal. Being sure and wrong is the most useful thing that can happen in a session, so answer honestly: it sends the unit back to learning and puts it at the front of your revision queue.

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?

How sure are you?

Correct: A. The correct answer is Gross margin 40%; Asset turnover 1.5x. Gross margin = (Revenue - COGS) / Revenue = ($1,200M - $720M) / $1,200M = $480M / $1,200M = 40%. Asset turnover = Revenue / Average Assets = $1,200M / $800M = 1.5x..
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.

Unit: financial-analysis-techniques