CFA Level 1 Financial Statement Analysis: notes and free practice
CFA Level 1 Financial Statement Analysis connects the income statement, balance sheet and cash-flow statement. Trace each accounting choice through the statements before interpreting a ratio or comparing two companies.
The key ideas, at a glance
Connect the statements
Read the visual, then follow the worked example below. Use the stated case assumptions.
Illustrative worked case
change in amount
- Cash / assets
- 30
- Debt / liabilities
- 30
- Revenue
- 0
The original case borrows 30 with no fees. Assets and liabilities rise together; no revenue is created.
| Concept | Rule or decision | Common mistake |
|---|---|---|
| Connect the statements | Assets = liabilities + equity | A cash inflow does not automatically increase profit. |
| Use a consistent denominator | Margin × asset turnover × leverage = ROE | Two companies with the same ROE may have very different operating and financing risks. |
| Bridge profit to operating cash | Start with profit; reverse noncash items and timing gaps | Adding back depreciation does not mean it creates cash. |
| Investigate before concluding | Accounting choice → reported amount → comparability | Capitalizing an eligible expenditure shifts expense timing; it does not eliminate expense forever. |
01Connect the statements
Assets = liabilities + equity
Watch for: A cash inflow does not automatically increase profit.
02Use a consistent denominator
Margin × asset turnover × leverage = ROE
Watch for: Two companies with the same ROE may have very different operating and financing risks.
03Bridge profit to operating cash
Start with profit; reverse noncash items and timing gaps
Watch for: Adding back depreciation does not mean it creates cash.
04Investigate before concluding
Accounting choice → reported amount → comparability
Watch for: Capitalizing an eligible expenditure shifts expense timing; it does not eliminate expense forever.
Selected 2026 study concepts. Match your preparation to your registered exam-year curriculum. These notes are not complete curriculum coverage.
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CFA Level I: 20 practice MCQs
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Put the method to work
One worked example, from facts to answer
Given
A business borrows $30 in cash with no fees.
Method
Cash increases by $30 and debt increases by $30.
Answer and interpretation
Assets and liabilities both rise; borrowing is not revenue.
Original independent teaching example. Assumptions are stated above; this is not an official exam question or scoring key.
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10 free Financial Statement Analysis questions
Choose an answer, check the reasoning, then use ‘Review the method’ to revisit the exact idea. Selected practice, not a complete syllabus or pass prediction.
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- Question 1 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
A company receives a $60,000 bank loan in cash, with no fees. At receipt, what happens to its accounting equation?
Answer and explanations
Cash increases assets and the loan increases liabilities by equal amounts; equity is unchanged at receipt.
Review the method- A: Borrowing creates a repayment obligation rather than an equity contribution.
- B - correct: Cash increases assets and the loan increases liabilities by equal amounts; equity is unchanged at receipt.
- C: Loan proceeds are financing, not earned revenue.
- Question 2 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
A company earns $900,000 net income, owes $100,000 preferred dividends and has 400,000 weighted-average common shares. Basic EPS is:
Answer and explanations
($900,000 - $100,000) / 400,000 = $2.00 attributable to each common share.
Review the method- A - correct: ($900,000 - $100,000) / 400,000 = $2.00 attributable to each common share.
- B: $2.25 divides total net income by common shares without deducting preferred dividends.
- C: $2.50 incorrectly adds preferred dividends to income available to common holders.
- Question 3 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
A service company earns $12,000 from services completed on credit this period. Assume revenue recognition criteria are met and no cash is collected yet. What initially increases?
Answer and explanations
The earned revenue is recognized with a receivable; collection later converts the receivable to cash.
Review the method- A: Cash has not been collected under the stated facts.
- B: A completed credit sale does not itself create borrowed debt or this expense entry.
- C - correct: The earned revenue is recognized with a receivable; collection later converts the receivable to cash.
- Question 4 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
Current assets are $240 and current liabilities $120. The company pays $40 of those liabilities using cash. The new current ratio is:
Answer and explanations
Both balances fall: ($240 - $40) / ($120 - $40) = $200 / $80 = 2.50.
Review the method- A: 1.67 reduces assets but leaves liabilities at their old amount.
- B - correct: Both balances fall: ($240 - $40) / ($120 - $40) = $200 / $80 = 2.50.
- C: 2.00 is the ratio before the payment; it does not remain unchanged here.
- Question 5 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
Net income is $45 on revenue of $300. What is net profit margin?
Answer and explanations
$45 / $300 = 15%; revenue is the denominator for net margin.
Review the method- A - correct: $45 / $300 = 15%; revenue is the denominator for net margin.
- B: Revenue divided by net income is 300/45 = 6.67 times, not 6.67%. Reversing the ratio and labeling it a percent does not calculate net margin.
- C: 45 is an income amount, not 45% of revenue.
- Question 6 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
Net margin is 8%, asset turnover is 1.25 and the equity multiplier is 2.0. Under the three-factor DuPont identity, ROE is:
Answer and explanations
0.08 × 1.25 × 2 = 0.20, or 20%, using consistent underlying measures.
Review the method- A: 10% is margin times turnover before including leverage.
- B: 16% multiplies margin by leverage but omits asset turnover.
- C - correct: 0.08 × 1.25 × 2 = 0.20, or 20%, using consistent underlying measures.
- Question 7 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
Net income is $70, depreciation $12, operating receivables increase $8 and operating payables increase $3. With no other adjustments, indirect operating cash flow is:
Answer and explanations
$70 + $12 - $8 + $3 = $77; receivables use cash and payables preserve cash relative to accrual income.
Review the method- A: $63 does not add back the noncash depreciation charge and apply the stated changes correctly.
- B - correct: $70 + $12 - $8 + $3 = $77; receivables use cash and payables preserve cash relative to accrual income.
- C: $93 adds the receivables increase when it should be subtracted.
- Question 8 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
Holding all other indirect-method adjustments constant, a $15 increase in operating inventory has what effect on operating cash flow relative to net income?
Answer and explanations
More cash is tied up in inventory than has flowed through expense, so subtract the increase.
Review the method- A - correct: More cash is tied up in inventory than has flowed through expense, so subtract the increase.
- B: Adding the increase would reverse the direction of the working-capital cash use.
- C: The inventory change is an operating working-capital adjustment in this setting.
- Question 9 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
Two otherwise identical companies incur the same eligible long-lived asset cost. One capitalizes it with only part depreciated this year; the other expenses all of it. Ignore taxes. The capitalizing company initially reports:
Answer and explanations
Recognizing only part of the cost as current depreciation leaves higher assets and current profit, assuming capitalization is appropriate.
Review the method- A: Capitalization retains the unexpired cost as an asset and defers part of the expense.
- B: Different expense timing creates differences until the cost has been fully recognized.
- C - correct: Recognizing only part of the cost as current depreciation leaves higher assets and current profit, assuming capitalization is appropriate.
- Question 10 of 10Level I topic sampleFinancial Statement AnalysisMultiple choice
Reported sales and profit rise while receivables grow much faster than sales and operating cash falls. What is the most defensible conclusion?
Answer and explanations
Examine credit terms, aging, collection and recognition policies to understand the divergence.
Review the method- A: These are warning signs, not conclusive proof of intentional misstatement.
- B - correct: Examine credit terms, aging, collection and recognition policies to understand the divergence.
- C: Cash-flow evidence is relevant when assessing the quality and sustainability of earnings.
Four ideas to put to work
Find the method you need
Start with: The accounting equation, accrual versus cash accounting, and basic ratio arithmetic.
METHOD 01
Connect the statements
Assets = liabilities + equity
- Trace each transaction through both sides of the accounting equation.
- Separate revenue earned from cash collected.
- Basic EPS = (net income - preferred dividends) / weighted-average common shares.
Worked example
- Given
- A business borrows $30 in cash with no fees.
- Calculate / decide
- Cash increases by $30 and debt increases by $30.
- Result
- Assets and liabilities both rise; borrowing is not revenue.
Watch for: A cash inflow does not automatically increase profit.
Practise this ideaMETHOD 02
Use a consistent denominator
Margin × asset turnover × leverage = ROE
- Current ratio uses balances at a point in time. Update both assets and liabilities after a cash payment.
- For annual returns, state the balance convention: average assets = (beginning + ending assets) / 2, and likewise for equity.
- DuPont multiplies net margin, asset turnover and the equity multiplier. Matched denominators reduce this to net income divided by average equity.
Worked example
- Given
- All amounts are USD millions for one year: revenue 300, net income 18, assets 180 at the start and 220 at the end; equity 90 and 110. Use simple average balances.
- Calculate / decide
- Average assets = 200 and equity = 100. Margin = 18/300 = 6%; turnover = 300/200 = 1.5 times; equity multiplier = 200/100 = 2 times. ROE = 0.06 × 1.5 × 2.
- Result
- ROE is 18%, matching 18/100. Using ending equity instead would give 16.36%, a different convention that must be labeled.
Change one fact
For liquidity, suppose current assets are 80 and current liabilities 100, then 20 of cash pays a current liability. All amounts use the same currency units.
Before: 80/100 = 0.80. After: (80 - 20)/(100 - 20) = 60/80 = 0.75.
The ratio falls when the starting ratio is below one. The sample’s above-one case rises. Paying a liability does not always improve this ratio.
Watch for: Two companies with the same ROE may have very different operating and financing risks.
Practise this ideaMETHOD 03
Bridge profit to operating cash
Start with profit; reverse noncash items and timing gaps
- Add back depreciation when starting from net income in the indirect method.
- An increase in operating receivables uses cash relative to recorded sales.
- An increase in operating payables preserves cash relative to recorded expenses.
Worked example
- Given
- All amounts are USD thousands for the same year: net income 50, depreciation 8, operating receivables increase 12 and operating payables increase 5. There are no other adjustments or classification differences.
- Calculate / decide
- Indirect operating cash flow = 50 + 8 - 12 + 5.
- Result
- Operating cash flow is USD 51 thousand. Depreciation reverses a noncash expense; it is not a cash receipt.
Change one fact
Keep the other amounts, but receivables decrease by 12 instead of increasing.
Use +12 for the decrease: 50 + 8 + 12 + 5 = 75.
Operating cash flow becomes USD 75 thousand. The 24 difference comes from replacing -12 with +12, not from adding 12 once.
Watch for: Adding back depreciation does not mean it creates cash.
Practise this ideaMETHOD 04
Investigate before concluding
Accounting choice → reported amount → comparability
- Read policies and estimates before comparing reported margins.
- Distinguish a warning sign from proof of manipulation.
- Check whether earnings are supported by sustainable cash collection.
Worked example
- Given
- Sales rise 10%, receivables rise 40% and operating cash falls.
- Calculate / decide
- Examine credit terms, collection history and revenue recognition.
- Result
- Investigate the divergence; those changes alone do not prove fraud.
Watch for: Capitalizing an eligible expenditure shifts expense timing; it does not eliminate expense forever.
Practise this ideaQuestions about this topic
- Why can profit and operating cash flow differ?
- Accrual timing, noncash expenses and working-capital changes create differences. Reconcile the income statement and cash-flow statement before concluding that the earnings are low quality.
- Should ratios use ending or average balances?
- Use the convention specified or appropriate to the ratio. Flow measures such as annual sales are often compared with average balances. Mixing average and ending denominators can distort comparisons.
- What does the DuPont relationship explain?
- It decomposes return on equity into profit margin, asset turnover and financial leverage under consistent definitions. The components show why ROE changed; a higher ROE is not automatically evidence of lower risk or better operating performance.
Apply the topic to a focused case
CFA Level 1 financial reporting quality: red flags
Begin with the business model and a multi-period comparison. Revenue recognized before collection creates receivables, so strong earnings with weaker operating cash flow may reflect normal growth or deteriorating collections. Reconcile the gap before interpreting it. Compare receivables growth, collection periods and subsequent receipts with sales and credit terms; an isolated ratio cannot identify the cause.
- Case facts
- Sales rise from 500 to 550 while receivables rise from 50 to 90. Assume no acquisition, reclassification or exchange-rate effect.
- Apply the method
- Sales growth is 10%; receivables growth is 80%. Ending receivables / annual sales rises from 10% to about 16.36%.
- Interpretation
- Collections or credit terms need investigation. These figures are a warning sign, not a conclusion that revenue is fabricated; check aging, terms and subsequent collections.
Independent teaching cases under the stated assumptions, rather than official questions or scoring keys.
Sources and curriculum scope
Official outlines establish curriculum scope. The explanations and worked examples are independent teaching material; the sources do not verify or endorse them.
- 2026 CFA Level I outline: Financial Statement Analysis
- 2026 CFA Level 1 curriculum outline
- Official Level 1 format and curriculum
- 2027 CFA Level 1 curriculum outline
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