CFA Level I Financial Statement Analysis Practice Questions

Correct answer: D. The company increased its use of financial leverage (debt); the main risk is elevated financial risk and potential difficulty servicing debt in a downturn.

The three-factor DuPont decomposition is ROE = Net Profit Margin × Asset Turnover × Financial Leverage (Assets/Equity). Since margin and turnover are stated as unchanged, the entire increase in ROE must be attributable to the third factor, financial leverage — meaning the company financed a larger share of assets with debt relative to equity. Higher leverage magnifies ROE in good times but also magnifies financial risk and the risk of distress if earnings decline.

• A. Incorrect — revenue growth alone, without a margin or turnover change, would not be captured in this framework as unchanged margin/turnover implies.
• B. Incorrect — a lower effective tax rate would raise net profit margin (net income/revenue), which the stem says is unchanged.
• C. Incorrect — operating efficiency improvements would show up in margin or turnover, both of which the stem says are flat.
• D. Correct — the only remaining DuPont factor, financial leverage, must explain the ROE change, consistent with a leverage-risk story.

Correct answer: B. Lower earnings quality, since a persistent gap between net income and operating cash flow driven by rising receivables can indicate aggressive accrual-based earnings management

A widening, persistent divergence between reported net income and operating cash flow, especially one associated with growing receivables and revenue recognized before cash is collected, is a classic red flag for lower earnings quality. It suggests income may be driven by accruals and judgment-laden estimates, such as aggressive revenue recognition, rather than by cash-generating operations, raising the risk of future earnings reversals, write-offs, or restatement. While accrual accounting is generally more informative than pure cash accounting for measuring economic performance, a large and growing net-income-to-cash-flow gap is a well-documented warning sign analysts specifically screen for, not a sign of strength. Choice C is a non sequitur since depreciation was not indicated, and D overstates accrual accounting's reliability by ignoring the specific manipulation risk described.

• A. Net income growth alone doesn't demonstrate quality; when it diverges from cash flow due to a rising receivables balance, that's a warning sign, not confirmation of strong profitability.
• B. A persistent gap between growing net income and flat/declining operating cash flow — especially with rising receivables and aggressive revenue recognition — is a red flag for low earnings quality and possible accrual-based earnings management.
• C. The scenario describes rising receivables and revenue recognition practices, not a depreciation method change, and this divergence very much bears on earnings quality.
• D. Accrual accounting isn't inherently more accurate than cash flow; a persistent divergence between the two driven by receivables growth is precisely what analysts scrutinize as a quality-of-earnings concern.

Correct answer: C. 24.0%

The basic three-factor DuPont decomposition is ROE = Net Profit Margin × Total Asset Turnover × Financial Leverage (Equity Multiplier) = 8% × 1.5 × 2.0 = 24.0%. Choice A (12%) results from multiplying only margin by turnover and forgetting the leverage multiplier. Choices B and D reflect other partial or arithmetic errors in combining the three components.

• A. 12.0% equals margin x turnover only (8% x 1.5), which is return on assets — it omits the equity (leverage) multiplier needed to get to ROE.
• B. 16.0% equals margin x equity multiplier only (8% x 2.0), omitting the asset turnover component of the three-factor decomposition.
• C. ROE = net profit margin x asset turnover x equity multiplier = 8% x 1.5 x 2.0 = 24.0%.
• D. 28.0% appears to add rather than multiply the two partial products (8% x 1.5 + 8% x 2.0 = 12% + 16% = 28%), rather than compounding all three factors together.

Correct answer: B. $123 million.

Start with $100 million of net income, add $20 million noncash depreciation, subtract the $15 million receivables increase, add the $10 million inventory decrease, and add the $8 million payables increase: CFO = $123 million.

• A. This wrongly subtracts the payables increase instead of adding it.
• B. 100 + 20 - 15 + 10 + 8 = $123 million.
• C. This adds the receivables increase, which is a use of cash and must be subtracted.
• D. This subtracts the inventory decrease and the payables increase, both of which are sources of cash.