Financial statement analysis and corporate finance
This domain examines how reported financials map to economic performance and how firms choose which projects to fund. Questions target ratio linkages, earnings quality and cost-of-capital arithmetic.
Core linkages
- DuPont: ROE = net margin × asset turnover × equity multiplier. Rising ROE driven only by the multiplier is lower quality.
- Cash conversion cycle = days inventory outstanding + days sales outstanding − days payables outstanding.
- Free cash flow to the firm = EBIT(1 − t) + D&A − capital expenditure − increase in net working capital.
Worked example
A firm has equity of 600, debt of 400, cost of equity 10%, pre-tax cost of debt 6% and a 25% tax rate. WACC = 0.6 × 10% + 0.4 × 6% × (1 − 0.25) = 6.0% + 1.8% = 7.8%. Reasoning: interest is tax-deductible, so the effective cost of debt is the after-tax 4.5%, not 6%. Market values, not book values, should weight the components.
Traps that cost marks
- Discounting project cash flows at firm-wide WACC when the project's risk differs.
- Treating a one-off working-capital release from stretched payables as sustainable profit.
- Mixing accrual earnings with cash flow when computing coverage ratios.
- Ignoring capitalised leases or capitalised development costs when comparing leverage.
- Using pre-tax cost of debt in WACC.