CFA Level II · CFA Level II Exam

Integration of Financial Statement Analysis Techniques: formula sheet

Full chapter guide

Key formulas

Five phases of the framework: Purpose and context → Collect data → Process data → Analyse and interpret → Conclude, communicate and follow up; Know the order. Adjusting statements belongs to the processing phase, before interpretation.
Common-size analysis: Common-size item = Line item ÷ Base (revenue for income statement, total assets for balance sheet); Use it to compare companies of different sizes or one company over time.
DuPont (three-step): ROE = Net profit margin × Asset turnover × Financial leverage; Net margin = Net income ÷ Revenue; Turnover = Revenue ÷ Average total assets; Leverage = Average total assets ÷ Average equity.
Adjusted leverage idea: Adjusted debt = Reported debt + Debt-like obligations (for example, underfunded pension deficit); Adjust for debt-like items disclosed in the statements or footnotes, and apply the same treatment to all companies compared.
Total accruals: Total accruals = Net income − Cash flow from operations (CFO); The cash flow accrual ratio goes one step further and also subtracts cash flow from investing (NI − CFO − CFI). Use the version the question asks for.
Balance sheet accrual ratio: Accrual ratio (BS) = (NOAend − NOAbeg) ÷ Average NOA; NOA = operating assets − operating liabilities, where operating assets = total assets − cash and marketable securities, and operating liabilities = total liabilities − total debt. Average NOA = (NOAbeg + NOAend) ÷ 2. A rising ratio suggests lower quality.
Cash flow accrual ratio: Accrual ratio (CF) = (NI − CFO − CFI) ÷ Average NOA; CFI = cash flow from investing. It measures earnings not backed by operating or investing cash flow, so higher values mean more of earnings lacks cash support. Compare across years and peers.
Cash flow to income conversion: CFO ÷ Net income; A ratio persistently below 1 or falling suggests earnings may be overstated. Judge the trend and the cause.
Net operating assets: NOA = Operating assets − Operating liabilities; Same NOA as in the balance sheet ratio: operating assets are total assets less cash and marketable securities, and operating liabilities are total liabilities less total debt. It is the scaling base for both accrual ratios.
FIFO inventory from LIFO: Inventory (FIFO) = Inventory (LIFO) + LIFO reserve; Raises current assets and working capital when prices rise.
FIFO COGS from LIFO: COGS (FIFO) = COGS (LIFO) − (Ending LIFO reserve − Beginning LIFO reserve); When prices rise the reserve grows, so FIFO COGS is lower and income higher.
Equity adjustment for LIFO: Equity (FIFO) = Equity (LIFO) + LIFO reserve × (1 − tax rate); The tax on the reserve is a deferred or extra tax liability.
Capitalised operating lease liability: Lease liability = PV of remaining lease payments at the lessee's borrowing rate; Add to debt and to assets by the same amount at inception. Needed only for a reporter that keeps operating leases off the balance sheet.
Lease expense reclassification: Interest = Liability × discount rate; Depreciation = Asset ÷ lease term; Operating lease expense is replaced by depreciation plus interest. EBITDA rises by the full lease expense. EBIT rises only by the lease expense less depreciation, because interest sits below EBIT. Total expense is front-loaded, so net income is lower in the early years.
Adjusted debt-to-equity: (Debt + lease liability) ÷ Equity; Equity usually unchanged at inception if asset equals liability.
3-step DuPont: ROE = (NI ÷ Sales) × (Sales ÷ Average total assets) × (Average total assets ÷ Average equity); Net profit margin × total asset turnover × equity multiplier.
5-step DuPont: ROE = (NI ÷ EBT) × (EBT ÷ EBIT) × (EBIT ÷ Sales) × (Sales ÷ Assets) × (Assets ÷ Equity); Tax burden × interest burden × EBIT margin × asset turnover × equity multiplier.
ROA from DuPont: ROA = NI ÷ Assets = Net profit margin × Asset turnover; Equals tax burden × interest burden × EBIT margin × turnover. It excludes the equity multiplier, but it is after interest and tax, so a fall in ROA can come from the interest burden (financing) as well as from EBIT margin or turnover. For the operating return, use EBIT margin × turnover.
Equity multiplier: Equity multiplier = Average total assets ÷ Average equity; A higher value means more debt financing. It raises ROE if ROA exceeds the cost of debt, and raises risk.
Cash conversion cycle: CCC = Days of inventory + Days of receivables − Days of payables; A shorter cycle means less cash tied up in working capital.
Liquidity ratios: Current ratio = Current assets ÷ Current liabilities; Quick ratio = (Cash + Marketable securities + Receivables) ÷ Current liabilities; Cash ratio = (Cash + Marketable securities) ÷ Current liabilities; Read them together with the cash conversion cycle.
Solvency ratios: Interest coverage = EBIT ÷ Interest expense; Debt-to-equity = Total debt ÷ Total equity; Check whether the definitions in the vignette match these.
Accruals ratio (balance sheet approach): Accruals ratio = [(NOA end − NOA begin)] ÷ Average NOA, where NOA = net operating assets = operating assets − operating liabilities = (Total assets − Cash and marketable securities) − (Total liabilities − Debt); A high or rising ratio means earnings rely on accruals rather than cash, a sign of lower quality.
Accruals ratio (cash flow approach): Accruals ratio = [Net income − (CFO + CFI)] ÷ Average NOA; Here cash flow is measured as CFO plus CFI. The curriculum uses both this approach and the balance sheet approach. A high or rising ratio signals lower earnings quality, as in the balance sheet approach.
Cash conversion of earnings: CFO ÷ Net income; A ratio persistently below 1 or falling over time is a warning sign. Check for working capital build-up.
Days sales outstanding: DSO = Average receivables ÷ Revenue × days in period; DSO rising while sales grow suggests aggressive credit terms or early recognition.
Capitalisation effect on a ratio: In the year of capitalisation: Income if expensed = Reported operating income − capitalised cost. In later years: Income if expensed = Reported operating income + amortisation charged on the capitalised cost; Expensing the cost lowers current earnings and CFO, and raises CFI by the same amount; total cash flow is unchanged.
FCFF from net income: FCFF = NI + NCC + Int(1 − t) − FCInv − WCInv; NCC is non-cash charges such as depreciation. FCInv is capital expenditure net of asset sales. WCInv is the increase in net working capital.
FCFF from EBIT: FCFF = EBIT(1 − t) + Dep − FCInv − WCInv; Use when the vignette gives EBIT and a tax rate.
FCFE from FCFF: FCFE = FCFF − Int(1 − t) + Net borrowing; Discount FCFE at the cost of equity. Discount FCFF at WACC.
Terminal value (Gordon growth): TV at time n = FCF(n+1) ÷ (r − g) = FCF(n) × (1 + g) ÷ (r − g); Needs r > g. Discount TV back from time n.
Sustainable growth: g = ROE × retention ratio; Use to check whether forecast growth is consistent with returns and payout.
Credit measures: Interest coverage = EBIT ÷ interest expense; Leverage = Debt ÷ EBITDA; Forecast these under base and downside cases and compare with stated thresholds.
Enterprise value to equity: Equity value = EV − Debt + Cash (and other non-operating assets) − other claims; Subtract non-controlling interest and preferred stock where given.

Quick revision

Follow the chapter workflow: framework, earnings quality, adjust, ratios and DuPont, red flags, then forecast and value.
Earnings supported by cash flow are generally higher quality than earnings driven by accruals.
A rising gap between net income and operating cash flow is a warning sign, not proof of manipulation.
Adjust for comparability before computing ratios, not after.
Capitalizing an expense raises current earnings and operating cash flow, and lowers investing cash flow.
Three-step DuPont: ROE = net profit margin × asset turnover × financial leverage.
Five-step DuPont: ROE = tax burden × interest burden × EBIT margin × asset turnover × leverage.
When explaining ROE, name the driver that changed and say whether it is sustainable.
Red flags include aggressive revenue recognition, slow-moving receivables or inventory, and unusual changes in estimates.
Unexplained changes in accounting policy or auditor deserve attention.
Forecasts should use adjusted figures and assumptions consistent with the vignette.
Answer from the vignette only, state IFRS or US GAAP treatment as the question specifies, and never leave a question blank since there is no penalty for wrong answers.

Common mistakes

Jumping into ratio calculations before identifying the purpose. Fix: Spend ten seconds finding the decision being made. Let it select the ratios.
Comparing companies without adjusting for different accounting policies. Fix: Check footnotes for policy differences and adjust one company to the other's basis before comparing.
Treating a low accrual ratio as always good or a high one as proof of manipulation. Fix: Say a high ratio is a warning to investigate. Growth businesses can have legitimate accruals.
Using ending NOA instead of average NOA in the cash flow accrual ratio. Fix: Follow the formula given in the vignette. Scale by average NOA unless told otherwise.
Adding the full LIFO reserve to equity without tax. Fix: Multiply the reserve by (1 − tax rate) for equity; the rest is a tax liability.
Using the ending LIFO reserve as the COGS adjustment. Fix: COGS adjusts only by the change in the reserve during the year.
Treating a higher ROE as automatically better performance. Fix: Check ROA and the equity multiplier. If ROE rose only because leverage rose, the gain comes with more financial risk, not better operations.
Reading the interest burden as interest expense. Fix: Interest burden is EBT ÷ EBIT. A higher value means less interest cost relative to EBIT. A fall in this ratio is a negative.
Treating a red flag as proof of fraud Fix: Say the flag warrants investigation. Look for legitimate explanations in the vignette, such as growth or acquisitions.
Getting the direction of capitalisation wrong Fix: Capitalising raises current income and assets, and moves the outflow from CFO to CFI. Later periods bear higher depreciation.

Exam tips

Read the first lines of every vignette for the purpose; the correct option nearly always serves it.
Remember the phase order, because questions often ask which step an action belongs to.
When adjusting, state the direction of the effect first (higher or lower debt, earnings, equity), then compute.
Be careful with IFRS and US GAAP: the vignette states which applies, and treatment can differ.
Do not spend more than about three minutes per question; there is no penalty for guessing, so answer every one.
Read the cash flow statement and the notes in every earnings quality item. The cause of the accrual gap is often there.
Know both accrual ratio formulas and their denominators. Questions often give NOA components and ask you to build NOA first.
Answer on direction. Many options differ only on aggressive versus conservative or higher versus lower quality.