CFA Level 1 - Financial Statement Analysis & Corporate Finance Flashcards

Question 1

3-Way DuPont Analysis Formula

Accepted Answer

Breaks down Return on Equity ($ROE$) into three distinct financial components:

$ROE = 	ext{Net Profit Margin} 	imes 	ext{Asset Turnover} 	imes 	ext{Financial Leverage}$

$ROE = \left(\frac{	ext{Net Income}}{	ext{Revenue}}ight) 	imes \left(\frac{	ext{Revenue}}{	ext{Average Total Assets}}ight) 	imes \left(\frac{	ext{Average Total Assets}}{	ext{Average Total Equity}}ight)$

Question 2

5-Way DuPont Analysis Breakdown

Accepted Answer

Expands $ROE$ into five distinct operational and financial drivers:

$ROE = 	ext{Tax Burden} 	imes 	ext{Interest Burden} 	imes 	ext{EBIT Margin} 	imes 	ext{Asset Turnover} 	imes 	ext{Financial Leverage}$

$ROE = \left(\frac{	ext{Net Income}}{	ext{EBT}}ight) 	imes \left(\frac{	ext{EBT}}{	ext{EBIT}}ight) 	imes \left(\frac{	ext{EBIT}}{	ext{Revenue}}ight) 	imes \left(\frac{	ext{Revenue}}{	ext{Average Assets}}ight) 	imes \left(\frac{	ext{Average Assets}}{	ext{Average Equity}}ight)$

Question 3

Free Cash Flow to Firm (FCFF) from Net Income

Accepted Answer

Represents cash available to all capital providers (debt and equity):

$	ext{FCFF} = 	ext{NI} + 	ext{NCC} + [	ext{Int} 	imes (1 - t)] - 	ext{FCInv} - 	ext{WCInv}$

- $	ext{NI}$: Net Income
- $	ext{NCC}$: Non-Cash Charges (e.g., Depreciation)
- $	ext{Int}$: Interest Expense
- $t$: Marginal Tax Rate
- $	ext{FCInv}$: Fixed Capital Investment
- $	ext{WCInv}$: Working Capital Investment

Question 4

Free Cash Flow to Equity (FCFE)

Accepted Answer

Represents cash available strictly to equity shareholders after debt payments and capital needs:

$	ext{FCFE} = 	ext{CFO} - 	ext{FCInv} + 	ext{Net Borrowing}$

Alternatively from Net Income:
$	ext{FCFE} = 	ext{NI} + 	ext{NCC} - 	ext{FCInv} - 	ext{WCInv} + 	ext{Net Borrowing}$

Question 5

Cash Flow Classifications: US GAAP vs. IFRS

Accepted Answer

Key cash flow reporting differences under both standards:

- **Interest Paid**: US GAAP $ightarrow 	ext{CFO}$; IFRS $ightarrow 	ext{CFO}$ or $	ext{CFF}$
- **Interest Received**: US GAAP $ightarrow 	ext{CFO}$; IFRS $ightarrow 	ext{CFO}$ or $	ext{CFI}$
- **Dividends Received**: US GAAP $ightarrow 	ext{CFO}$; IFRS $ightarrow 	ext{CFO}$ or $	ext{CFI}$
- **Dividends Paid**: US GAAP $ightarrow 	ext{CFF}$; IFRS $ightarrow 	ext{CFO}$ or $	ext{CFF}$
- **Taxes Paid**: US GAAP $ightarrow 	ext{CFO}$; IFRS $ightarrow 	ext{CFO}$ (unless specifically linked to $	ext{CFI}$ or $	ext{CFF}$)

Question 6

LIFO to FIFO Balance Sheet Adjustments

Accepted Answer

To convert inventory and equity from LIFO to FIFO for comparison:

1. $	ext{Inventory}_{	ext{FIFO}} = 	ext{Inventory}_{	ext{LIFO}} + 	ext{LIFO Reserve}$
2. $	ext{Retained Earnings}_{	ext{FIFO}} = 	ext{Retained Earnings}_{	ext{LIFO}} + [	ext{LIFO Reserve} 	imes (1 - t)]$
3. $	ext{Cash}_{	ext{FIFO}} = 	ext{Cash}_{	ext{LIFO}} - [	ext{LIFO Reserve} 	imes t]$

Question 7

LIFO to FIFO Cost of Goods Sold (COGS)

Accepted Answer

To convert COGS from LIFO to FIFO:

$	ext{COGS}_{	ext{FIFO}} = 	ext{COGS}_{	ext{LIFO}} - (\Delta 	ext{LIFO Reserve})$

- In periods of rising prices, FIFO COGS is lower than LIFO COGS, leading to higher gross profit and higher net income under FIFO.

Question 8

Net Present Value (NPV) Formula & Rule

Accepted Answer

Calculates the total present value of cash inflows minus initial outlay ($CF_0$):

$	ext{NPV} = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t} - CF_0$

- **Decision Rule**: Accept independent projects if $	ext{NPV} > 0$. Select the project with the highest positive $	ext{NPV}$ among mutually exclusive projects.

Question 9

Internal Rate of Return (IRR) Formula & Rule

Accepted Answer

The discount rate $r$ that forces the net present value of all cash flows to equal zero:

$\sum_{t=1}^{n} \frac{CF_t}{(1 + 	ext{IRR})^t} - CF_0 = 0$

- **Decision Rule**: Accept project if $	ext{IRR} > 	ext{Required Rate of Return } (r)$.

Question 10

Profitability Index (PI)

Accepted Answer

Measures value created per unit of investment:

$	ext{PI} = \frac{	ext{Present Value of Future Cash Flows}}{	ext{Initial Outlay}} = 1 + \frac{	ext{NPV}}{CF_0}$

- **Decision Rule**: Accept project if $	ext{PI} > 1.0$.

Question 11

Weighted Average Cost of Capital (WACC)

Accepted Answer

Overall required return on capital for a firm:

$	ext{WACC} = (w_d 	imes r_d 	imes (1 - t)) + (w_p 	imes r_p) + (w_e 	imes r_e)$

- $w_d, w_p, w_e$: Target market value weights of debt, preferred stock, and common equity
- $r_d 	imes (1 - t)$: After-tax cost of debt
- $r_p$: Cost of preferred stock
- $r_e$: Cost of common equity

Question 12

Cost of Equity via CAPM

Accepted Answer

Determines the required return on equity based on systematic risk:

$r_e = R_f + \beta_e 	imes [E(R_m) - R_f]$

- $R_f$: Risk-free rate
- \beta_e: Equity beta
- $[E(R_m) - R_f]$: Equity market risk premium

Question 13

Liquidity Ratios: Current, Quick, and Cash Ratios

Accepted Answer

- **Current Ratio**: $\frac{	ext{Current Assets}}{	ext{Current Liabilities}}$
- **Quick Ratio**: $\frac{	ext{Cash} + 	ext{Marketable Securities} + 	ext{Receivables}}{	ext{Current Liabilities}}$
- **Cash Ratio**: $\frac{	ext{Cash} + 	ext{Marketable Securities}}{	ext{Current Liabilities}}$

Question 14

Interest Coverage Ratio

Accepted Answer

Solvency ratio measuring the ability to cover interest payments on debt:

$	ext{Interest Coverage} = \frac{	ext{EBIT}}{	ext{Interest Expense}}$

- Higher ratios indicate greater solvency and lower risk of default.

Question 15

Degree of Operating Leverage (DOL)

Accepted Answer

Measures the sensitivity of operating income (EBIT) to changes in sales units:

$	ext{DOL} = \frac{\% \Delta 	ext{EBIT}}{\% \Delta 	ext{Sales}} = \frac{Q(P - V)}{Q(P - V) - F}$

- $Q$: Units sold, $P$: Price, $V$: Variable cost per unit, $F$: Fixed operating costs.

Question 16

Degree of Financial Leverage (DFL)

Accepted Answer

Measures the sensitivity of net income or Earnings Per Share (EPS) to changes in operating income (EBIT):

$	ext{DFL} = \frac{\% \Delta 	ext{EPS}}{\% \Delta 	ext{EBIT}} = \frac{	ext{EBIT}}{	ext{EBIT} - 	ext{Interest}}$

Question 17

Sustainable Growth Rate (SGR)

Accepted Answer

The maximum rate at which a company can grow without issuing new equity:

$g = b 	imes 	ext{ROE}$

- Retention Rate ($b$): $1 - 	ext{Dividend Payout Ratio} = 1 - \left(\frac{	ext{Dividends}}{	ext{Net Income}}ight)$

Question 18

Cash Conversion Cycle (CCC)

Accepted Answer

Measures time required to convert investments in inventory into cash:

$	ext{CCC} = 	ext{DOH} + 	ext{DSO} - 	ext{DOS}$

- **DOH (Days of Inventory On Hand)**: $\frac{	ext{Inventory}}{	ext{COGS}} 	imes 365$
- **DSO (Days Sales Outstanding)**: $\frac{	ext{Receivables}}{	ext{Revenue}} 	imes 365$
- **DOS (Days Payable Outstanding)**: $\frac{	ext{Payables}}{	ext{COGS}} 	imes 365$

Question 19

Asset Impairment Testing: US GAAP vs. IFRS

Accepted Answer

- **US GAAP**: 2-step test. Impaired if $	ext{Carrying Value} > 	ext{Undiscounted Future Cash Flows}$. Loss = $	ext{Carrying Value} - 	ext{Fair Value}$. *Reversals prohibited*.
- **IFRS**: Impaired if $	ext{Carrying Value} > 	ext{Recoverable Amount}$ (where Recoverable Amount = $\max(	ext{Fair Value less costs to sell}, 	ext{Value in Use})$). *Reversals allowed*.

Question 20

Deferred Tax Assets (DTA) vs. Deferred Tax Liabilities (DTL)

Accepted Answer

- **DTL**: Created when $	ext{Taxable Income} < 	ext{Pretax Accounting Income}$ (due to temporary timing differences). Taxes paid are lower now, resulting in higher future tax liabilities.
- **DTA**: Created when $	ext{Taxable Income} > 	ext{Pretax Accounting Income}$. Taxes paid are higher now, resulting in future tax savings.

CFA Level 1 - Financial Statement Analysis & Corporate Finance

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