Financial

Statement Analysis
CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
A. Evaluate a company’s past financial performance and explain how a
company’s strategy is reflected in past financial performance

QUESTION 1
A financial analyst determines that a company appears to be in the process of
accumulating a “war chest.” It is most likely that she will conclude that it will be
used for:
A. recapitalization.
B. strategic acquisitions.
C. share buybacks.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
B is correct.
The term “war chest” refers to large cash balances that a company accumulates,
normally used to finance strategic acquisitions.
A is incorrect because recapitalization involves restructuring a company’s equity
capital, often as a response to financial distress. At this point, the company is
usually very short of cash, not flush with cash.
C is incorrect because companies that buy back large blocks of shares are often
looking for a way to distribute excess cash accumulations, rather than actively
trying to accumulate it. The term “war chests” is associated with a more
purposeful accumulation.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
A. Evaluate a company’s past financial performance and explain how a
company’s strategy is reflected in past financial performance

QUESTION 2
A cell phone manufacturer has switched to high-margin premium-priced
products with the most innovative features as part of its product differentiation
strategy. Which of the following other changes is most consistent with this
strategy?
A. An increase in inventory levels
B. A decrease in research and development expenditures
C. An increase in advertising expenditures

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
C is correct.
Expenditures on advertising and research are required to support a product
differentiation strategy. The effect on inventory is uncertain.
A is incorrect because it is uncertain what the impact on inventory would be.
B is incorrect because R&D expenditures would be expected to increase.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
B. Forecast a company’s future net income and cash flow

QUESTION 3
An analyst is forecasting the gross profit of the following three companies. He
uses the five-year average gross margins and forecasts sales based on an internal
model.

Company Additional Information

Company 1 Introduced new products last year for the first
time in the past 10 years but with the most
advanced technology
Company 2 Has been offering the same products with the
same technology throughout the period, and the
demand and cost structures for their products
have not experienced any significant changes

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS

Company Additional Information

Company 3 Renews its product offerings constantly as part of
its corporate policy

For which of the three companies will the forecast of gross profit
be most reliable?
A. Company 3
B. Company 2
C. Company 1

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
B is correct.
Company 2 will have the most reliable forecast because it has been offering the
same products with the same technology, and their demand and cost structures
have been stable too. Therefore, the relationship between sales and gross profit
(i.e., gross margin) should be stable, and the use of average gross margins will be
the most reliable.
A is incorrect because Company 3 has been renewing its product offerings
constantly, usually resulting in a less stable relationship between sales and gross
profit.
C is incorrect because Company 1 recently introduced new products, usually
causing a less stable relationship between sales and gross profit.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
C. Describe the role of financial statement analysis in assessing the credit
quality of a potential debt investment

QUESTION 4
A credit rating agency uses “scale and diversification” as one of its metrics to
assess credit risk. Which of the following would most likely be included in that
category?
A. Purchasing power with suppliers
B. Cost structure
C. Operating cash flow less dividends

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
A is correct.
Borrowers can better withstand adverse events when they have more purchasing
power with suppliers. Purchasing power reflects the organization’s scale.
B is incorrect because this measure would be of interest to credit analysts, but as
an indication of operational efficiency rather than scale and diversification.
C is incorrect because this measure would be of interest to credit analysts, but as
an indication of tolerance for leverage rather than scale and diversification.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
C. Describe the role of financial statement analysis in assessing the credit
quality of a potential debt investment

QUESTION 5
An analyst has observed that the profit margins of a company have not increased
or decreased significantly in the last few years. Which of the following is
the most appropriate inference that can be made as to how this observation
affects the company’s credit risk? The company’s credit risk is:
A. unaffected.
B. lower than otherwise.
C. higher than otherwise.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
B is correct.
With no significant increases or decreases in margins in the last few years, the
company has had stable margins. Stable margins are associated with lower credit
risk.
A is incorrect because stable margins are associated with lower credit risk than
otherwise.
C is incorrect because with no significant increases or decreases in margins in the
last few years, the company has had stable margins. Stable margins are generally
associated with lower credit risk.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
C. Describe the role of financial statement analysis in assessing the credit
quality of a potential debt investment

QUESTION 6
A credit analyst considers selected ratios calculated for three companies:

Company A Company B Company C

EBITDA/Average assets 8.4% 6.2% 4.3%
Debt/EBITDA 2.0 2.8 3.5
Inventory turnover 4.2 5.8 6.3

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Based on the information given, which company is most likely to receive the
highest credit rating?
A. Company C
B. Company A
C. Company B

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
B is correct.
Company A has the highest EBITDA/Average assets and the lowest Debt/EBITDA.
It is likely to receive the highest credit rating since these measures suggest it is
best able to repay debt. Inventory turnover does not measure debt paying ability.
A is incorrect because company C is less able to repay its debt based on its lower
EBITDA/Average Assets and its higher Debt/EBITDA.
C is incorrect because company B is less able to repay its debt based on its lower
EBITDA/Average Assets and its higher Debt/EBITDA.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
D. Describe the use of financial statement analysis in screening for potential
equity investments

QUESTION 7
When using ratios to screen for potential equity investments, analysts
can most effectively control for exposure to which of the following risks?
A. Regulatory
B. Financial
C. Technological

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
B is correct.
Ratio analysis provides a quick and direct way of comparing metrics addressing
financial risk across a pool of companies.
A is incorrect because regulatory risk is not readily assessed by ratio analysis.
This risk is more likely to be assessed based on knowledge of regulatory trends,
and the likely impact of regulatory change on individual companies.
C is incorrect because technological risk is not readily assessed by ratio analysis.
This risk is more likely to be assessed based on knowledge of technology trends
in the market and the technological expertise of individual companies.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
D. Describe the use of financial statement analysis in screening for potential
equity investments

QUESTION 8
An equity manager conducted a stock screen on 5,000 US stocks that comprise
her investment universe. The results of the screen are presented in the table
below.

Percent of Stocks Meeting

Criterion Criterion
Price per share/Sales per share < 1.25 35.0
Total asset/Equity ≤ 2.5 48.2
Dividends > 0 58.6
Consensus forecast earnings per share 75.0

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS

Percent of Stocks Meeting

Criterion Criterion
>0
Meeting all four criteria 10.8
simultaneously

If all the criteria are independent of each other, the number of stocks meeting all
four criteria would be closest to:
A. 293
B. 371
C. 540

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
B is correct.
If the criteria are independent of one another, the probability that all will occur is
the product of the individual probabilities (multiplication rule for independent
events)—that is 0.35 × 0.482 × 0.586 × 0.75 = 0.074, or 7.4%, which would
produce 7.4% × 5,000 = 371 meeting the criteria.
A is incorrect because it is the average of the probabilities × the probability of
meeting all 4 × 5,000:

  0.35 + 0.482 + 0.586 + 0.75  

  × 0.18  × 5, 000 = 293
 4  
C is incorrect because it is the 10.8% probability of simultaneously meeting the
requirement in the sample: 10.8% × 5,000 = 540.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
D. Describe the use of financial statement analysis in screening for potential
equity investments

QUESTION 9
An analyst uses a stock screener and selects the following metrics from his equity
universe:
 price-to-equity ratio lower than the median P/E
 price-to-book value ratio lower than the median P/BV
The stocks selected would be most appropriate for portfolios for which type of
investors?
A. Value investors
B. Growth investors
C. Market-oriented investors

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
A is correct.
Metrics such as low P/E and low P/BV are aimed at selecting value companies;
therefore, the portfolio is most appropriate for value investors.
B is incorrect because growth investors would include metrics focused on
earnings growth or momentum, such as sales increases for the past three years.
C is incorrect because screens for market-oriented investors would not
emphasize the value metrics included in this screen.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
E. Explain appropriate analyst adjustments to a company’s financial
statements to facilitate comparison with another company

QUESTION 10
When analyzing a company that prepares its financial statements according to US
GAAP, calculating the ratio of price to tangible book value instead of the ratio of
price to book value is most appropriate if the company:
A. grows primarily through acquisitions.
B. develops its patents and processes internally.
C. invests a substantial amount in new capital assets.

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CFA LEVEL - 1 FINANCIAL STATEMENT ANALYSIS
Solution
A is correct.
A company that grows primarily through acquisitions will have more goodwill
and other intangible assets on its balance sheet than a company with fewer
acquisitions or that has grown internally. To provide for comparisons with
companies that do not follow such a growth strategy, an analyst would remove all
intangibles and focus on tangible book value.
B is incorrect because if the company has grown internally, it will not have many
intangible assets, so book value and tangible book value would be very similar.
Therefore, the adjusted ratio is not necessary.
C is incorrect because the investment in new capital assets would increase both
the book value and the tangible book value—the adjustment would not make any
difference.

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