Financial Analysis
Core concepts
Financial analysis on the FPAC exam centers on reading the three statements as one integrated system. A candidate must be fluent in ratio families (liquidity, solvency/leverage, activity/efficiency, profitability, and market valuation), the cash conversion cycle, working-capital management, time value of money, capital budgeting metrics (NPV, IRR, payback, discounted payback, profitability index), cost of capital (WACC), and basic variance and break-even analysis. Know the DuPont decomposition: ROE = net profit margin x asset turnover x equity multiplier.
Traps to watch
- Averages vs. ending balances. Turnover and return ratios usually use average balances; questions that supply only an ending balance often intend that figure, so read what is given.
- NPV vs. IRR conflicts. For mutually exclusive projects, rank by NPV; IRR can mislead when scale or timing differs.
- Payback ignores cash flows after the cutoff and the time value of money unless discounted payback is specified.
- Sunk costs are irrelevant; opportunity and incremental costs are relevant.
- Contribution margin vs. gross margin are not interchangeable in CVP problems.
- Debt is added at market value and after tax in WACC (interest is tax-deductible), while equity cost is not tax-adjusted.
Worked example
A project costs $100,000, returns $40,000 per year for four years, and the firm's WACC is 10%. The annuity factor for 4 years at 10% is 3.170. PV of inflows = $40,000 x 3.170 = $126,800; NPV = $26,800, so accept. Payback is 2.5 years ($100,000 / $40,000). Rule of thumb: if NPV is positive, IRR exceeds the hurdle rate, and the profitability index exceeds 1.0 - these three signals should agree for a single independent project.