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FPAC: Financial Analysis

FPAC · Work through your exam, one topic at a time.

All guide sections

Financial Analysis

The Financial Analysis domain tests whether you can turn statements into decision-ready insight: ratio construction, common-size and trend analysis, cost-volume-profit (CVP) reasoning, variance decomposition, capital budgeting, and cash conversion. Questions often provide a compact data set and ask which conclusion is supportable, so marks sit in method and interpretation rather than recall.

Ratio families and what they signal

  • Liquidity: current, quick, and cash ratios; interpret alongside the cash conversion cycle, not in isolation.
  • Solvency: debt-to-equity, net debt/EBITDA, interest coverage (EBIT/interest).
  • Activity: AR turnover and DSO, inventory turnover and DIO, DPO, and CCC = DIO + DSO − DPO.
  • Profitability: gross, operating, and net margin; ROA; ROE.
  • Common-size analysis: income statement lines as % of revenue; balance sheet lines as % of total assets. Trend analysis indexes a base year to 100; both strip scale but not accounting-policy differences. Use average balance-sheet balances when the ratio compares a flow with a stock; use ending balances only when the question specifies.

DuPont, CVP, and capital budgeting

DuPont decomposes ROE = net margin × asset turnover × equity multiplier, separating operating performance from financing. CVP: contribution margin (CM) = revenue − variable costs; breakeven units = fixed costs / CM per unit; operating leverage = CM / operating income. For capital projects, NPV measures value creation; IRR can mislead with non-conventional cash flows, and payback ignores cash flows after the cutoff.

Worked example

Revenue 1,000; COGS 600; operating expenses 250; interest 40; tax 22; net income 88. Total assets 800; equity 400. ROE = 88/400 = 22%. DuPont: net margin 8.8% × asset turnover 1.25 × equity multiplier 2.0 = 22%. If asset turnover falls to 1.0 with all else unchanged, ROE falls to 17.6%. The reasoning matters: the decline is an operating-efficiency issue, not a margin or leverage issue, so a cost-cutting recommendation would miss the driver.

Traps

  • Mixing markup and margin: a 25% markup is a 20% margin.
  • Ignoring sales mix in variance analysis; volume can rise while margin falls.
  • Using year-end balances for flow/stock ratios when averages are appropriate.
  • Comparing ratios across industries without a benchmark.
  • Treating negative working capital as always favorable; it can signal distress.
  • Using EBITDA and EBIT interchangeably in coverage ratios.