Financial Analysis and Performance Measurement
What CB1 tests in financial analysis and performance measurement
This domain tests your ability to interpret financial statements, compare performance and judge whether reported profit reflects economic reality. Expect ratio construction, DuPont decomposition, cash-flow quality and value-based measures.
Core rules and concepts
- Profitability ratios include net margin, return on assets and return on equity. Liquidity ratios include current and quick ratios; leverage ratios include debt-to-equity and interest cover.
- Efficiency ratios include asset turnover and receivables days. Use average balances where flows are compared with stocks.
- DuPont analysis decomposes ROE into net profit margin × asset turnover × equity multiplier, separating operating, asset-use and financing effects.
- Economic value added is NOPAT minus WACC multiplied by invested capital. It charges for equity capital, unlike accounting profit.
- Accruals, accounting policies, one-offs and lease treatment can distort comparability; always check cash conversion.
Worked example
A company has sales 600, net income 60, assets 400 and equity 250. Net margin = 60/600 = 10%; asset turnover = 600/400 = 1.5; equity multiplier = 400/250 = 1.6. ROE = 10% × 1.5 × 1.6 = 24%. If ROE rose only because the equity multiplier increased, the improvement is due to leverage and adds financial risk, not operating efficiency.
Traps that cost marks
Do not compare ratios across firms without checking accounting policies and industry norms. Do not use year-end balances when average balances are more appropriate. A rising gross margin is not automatically good if receivables or inventory are ballooning. Ignore one-off gains when assessing sustainable performance.