A company reports ROE of 12% in Year 1, rising to 18% in Year 2. A three-factor DuPont decomposition shows that net profit margin and total asset turnover were essentially unchanged between the two years. Which of the following best explains the ROE increase, and what is a key risk associated with it?

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

An analyst notes that a company's net income has grown steadily for three consecutive years, but its cash flow from operations has been flat to declining over the same period, driven largely by a rising accounts receivable balance and aggressive revenue recognition on long-term contracts. This pattern is most likely a signal of:

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 company receives cash from a customer as an advance payment for services it has not yet performed. This transaction should be recorded as:

A liability (unearned or deferred revenue) on the balance sheet

A company uses LIFO for inventory accounting during a period of rising prices. Its LIFO reserve was $30 million at the beginning of the year and $40 million at year-end. If an analyst wanted to restate the current year's financial statements as if the company used FIFO, which adjustment is correct?

FIFO ending inventory would be $40 million higher than reported LIFO inventory, and FIFO COGS would be $10 million lower than LIFO COGS.

During a period of steadily rising input prices, a company using FIFO is compared with an otherwise identical company using weighted-average cost. Assuming positive inventory and sales, which FIFO result is generally expected?

Lower cost of goods sold, higher ending inventory, and higher gross profit.

CFA Level I Financial Statement Analysis Practice Questions

Official outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes)
Questions on this page: 8
Updated: Nov 3, 2026
Share of the exam: 11-14%

Question 1, medium
A company reports ROE of 12% in Year 1, rising to 18% in Year 2. A three-factor DuPont decomposition shows that net profit margin and total asset turnover were essentially unchanged between the two years. Which of the following best explains the ROE increase, and what is a key risk associated with it?
- A.The company increased revenue growth; the main risk is customer concentration.
- B.The company reduced its effective tax rate; the main risk is regulatory reversal of the tax benefit.
- C.The company improved operating efficiency; the main risk is margin compression from competitors.
- 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.
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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.
- Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026
Question 2, hard
An analyst notes that a company's net income has grown steadily for three consecutive years, but its cash flow from operations has been flat to declining over the same period, driven largely by a rising accounts receivable balance and aggressive revenue recognition on long-term contracts. This pattern is most likely a signal of:
- A.Improving earnings quality, since steady net income growth over three years shows strong and sustainable core profitability
- 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
- C.Neutral earnings quality, since the gap reflects ordinary timing differences that reverse within a normal operating cycle
- D.Higher earnings quality, since growing receivables show customers accept the company's credit terms and demand is rising
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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. A gap that persists for three years and keeps growing is not an ordinary timing difference that reverses within a normal operating cycle, so calling it neutral misses the warning sign. Rising receivables also do not prove that customers accept the credit terms or that demand is strong, because the cash has not been collected. The steady net income growth does not show sustainable profitability when operating cash flow is flat to declining.
- A. Net income growth alone does not show sustainable profitability. When it diverges from flat or declining operating cash flow because receivables keep rising, the earnings are not turning into cash, which is a warning sign rather than confirmation of strength.
- 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. Ordinary timing differences reverse within an operating cycle. A gap that persists for three years while receivables keep building is not a normal timing difference, so it does bear on earnings quality.
- D. Rising receivables can reflect sales growth, but here they absorb cash while revenue is recognized aggressively. Revenue that is not being collected is a quality concern, not evidence of stronger demand.
- Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026
Question 3, medium
A company reports a net profit margin of 8%, total asset turnover of 1.5x, and a financial leverage (equity) multiplier of 2.0x. Using the DuPont decomposition, the company's return on equity (ROE) is:
- A.12.0%
- B.16.0%
- C.24.0%
- D.28.0%
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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.
- Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026
Question 4, medium
A firm reports net income of $100 million, depreciation of $20 million, an increase in receivables of $15 million, a decrease in inventory of $10 million, and an increase in accounts payable of $8 million. Assume no other reconciling items. What is cash flow from operations under the indirect method?
- A.$107 million.
- B.$123 million.
- C.$153 million.
- D.$87 million.
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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.
- Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026
Question 5, easy
A company receives cash from a customer as an advance payment for services it has not yet performed. This transaction should be recorded as:
- A.Revenue on the income statement immediately
- B.A liability (unearned or deferred revenue) on the balance sheet
- C.An increase to retained earnings
- D.An operating expense on the income statement
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Correct answer: B. A liability (unearned or deferred revenue) on the balance sheet
Under accrual accounting, revenue is recognized when it is earned, i.e., when the related performance obligation is satisfied, not simply when cash is received. Cash received before goods or services are delivered creates a liability, unearned or deferred revenue, representing the company's obligation to perform in the future. It becomes revenue only as the service is delivered. Choice A misapplies cash-basis logic, C confuses a liability with equity, and D mischaracterizes a customer prepayment as an expense.
- A. Incorrect. Recognizing revenue immediately would violate the revenue recognition principle, since the service hasn't yet been performed.
- B. Correct. Cash received before the related service is performed is recorded as a liability (unearned or deferred revenue) until the performance obligation is satisfied.
- C. Incorrect. The payment doesn't directly increase retained earnings; retained earnings changes only through recognized net income and dividends, not through unearned cash receipts.
- D. Incorrect. This transaction represents a future obligation to the customer, a liability, not a current expense on the income statement.
- Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026
Question 6, hard
A company uses LIFO for inventory accounting during a period of rising prices. Its LIFO reserve was $30 million at the beginning of the year and $40 million at year-end. If an analyst wanted to restate the current year's financial statements as if the company used FIFO, which adjustment is correct?
- A.FIFO ending inventory would be $40 million lower than reported LIFO inventory, and FIFO COGS would be $10 million higher than LIFO COGS.
- B.FIFO ending inventory would be $30 million higher than reported LIFO inventory, and FIFO COGS would be $10 million higher than LIFO COGS.
- C.FIFO ending inventory would be $40 million higher than reported LIFO inventory, and FIFO COGS would be $40 million lower than LIFO COGS.
- D.FIFO ending inventory would be $40 million higher than reported LIFO inventory, and FIFO COGS would be $10 million lower than LIFO COGS.
Show answer and explanationHide answer
Correct answer: D. FIFO ending inventory would be $40 million higher than reported LIFO inventory, and FIFO COGS would be $10 million lower than LIFO COGS.
FIFO inventory = LIFO inventory + LIFO reserve, so FIFO ending inventory is $40 million (the ending reserve) higher than reported. FIFO COGS = LIFO COGS − change in LIFO reserve during the year; the reserve increased by $10 million ($40M − $30M), so FIFO COGS is $10 million lower than LIFO COGS (equivalently, FIFO net income before tax is $10 million higher).
- A. Incorrect. Reverses the direction of both adjustments; FIFO inventory should be higher, not lower, and FIFO COGS should be lower, not higher, in a rising-price environment.
- B. Incorrect. Uses the beginning-year reserve ($30M) for the inventory adjustment instead of the ending reserve ($40M), and gets the COGS direction wrong.
- C. Incorrect. Applies the ending reserve level ($40M) to COGS as well as inventory, when only the change in the reserve ($10M) belongs in the COGS adjustment.
- D. Correct. Applies the ending reserve level ($40M) to inventory and the change in reserve ($10M) to COGS, correctly and in the correct direction.
- Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026
Question 7, medium
During a period of steadily rising input prices, a company using FIFO is compared with an otherwise identical company using weighted-average cost. Assuming positive inventory and sales, which FIFO result is generally expected?
- A.Higher cost of goods sold and lower ending inventory, because the most recent and most expensive purchases are expensed first.
- B.Lower gross margin and lower current assets, because older and cheaper costs remain in ending inventory under this method.
- C.Identical net income, because total purchases are identical and the cost flow assumption affects labeling rather than reported profit.
- D.Lower cost of goods sold, higher ending inventory, and higher gross profit.
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Correct answer: D. Lower cost of goods sold, higher ending inventory, and higher gross profit.
FIFO expenses the oldest, cheapest costs and leaves recent, higher costs in ending inventory, so with rising prices it reports lower COGS, higher inventory and higher gross profit than weighted average.
- A. Expensing the newest, costliest purchases first describes LIFO, not FIFO.
- B. Under FIFO the newest, higher costs stay in ending inventory, which raises current assets and gross margin.
- C. The cost flow assumption changes the split between COGS and inventory, so reported income differs.
- D. FIFO charges older cheaper costs to sales and holds newer higher costs in inventory.
- Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026
Question 8, medium
A company reports cost of goods sold of $600,000, net sales of $900,000, beginning inventory of $90,000, and ending inventory of $110,000. The company's inventory turnover ratio for the period is closest to:
- A.6.0x
- B.9.0x
- C.5.45x
- D.8.18x
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Correct answer: A. 6.0x
Inventory turnover equals cost of goods sold divided by average inventory. Average inventory = ($90,000 + $110,000) / 2 = $100,000. Turnover = $600,000 / $100,000 = 6.0x. Choice B ($900,000 / $100,000 = 9.0x) mistakenly uses net sales revenue in the numerator instead of COGS. Choice C ($600,000 / $110,000 ≈ 5.45x) uses only ending inventory rather than the average. Choice D ($900,000 / $110,000 ≈ 8.18x) compounds both errors, wrong numerator and wrong denominator.
- A. Inventory turnover = COGS / average inventory = $600,000 / [($90,000+$110,000)/2] = $600,000/$100,000 = 6.0x.
- B. 9.0x results from dividing net sales, not COGS, by average inventory ($900,000/$100,000), which mismatches the numerator convention for this ratio.
- C. 5.45x uses ending inventory alone ($600,000/$110,000) rather than the average of beginning and ending inventory.
- D. 8.18x combines two errors: using net sales instead of COGS and ending inventory instead of average inventory ($900,000/$110,000).
- Source: Exam outline: CFA Institute 2026 Level I Topic Outlines (learning outcomes), accessed October 2026

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