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CFA Level I · CFA Level I Exam · Company Analysis: Past, Present, and Future

A firm's net profit margin was 8.0% in Year 1 and 8.0% in Year 2, but its gross margin fell from 40% to 36% over the period. The most likely explanation consistent with these facts is that:

The most likely explanation is that selling and administrative expenses fell as a percentage of sales. Gross margin declined four points, so something below gross profit must have offset it to keep net margin at 8.0%. A lower cost ratio would raise gross margin, and higher taxes would lower net margin.

  1. Aselling and administrative expenses fell as a percentage of salesCorrect
  2. Bthe cost of goods sold fell as a percentage of sales
  3. Cthe firm's income tax rate increased in Year 2

Explanation

A lower gross margin hurts profit unless offset below the gross profit line. A fall in operating expense ratios could offset the 4-point gross margin decline and leave net margin unchanged. Lower COGS would raise gross margin, and a higher tax rate would reduce net margin further.

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