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CFA Level I · CFA Level I Exam · Analyzing Statements of Cash Flows II

An analyst prepares a common-size cash flow statement using revenue as the base. Operating cash flow was 18% of revenue in Year 1 and 11% in Year 2, while net income as a percentage of revenue was steady at 10%. The analyst would most likely conclude that earnings quality in Year 2:

Earnings quality most likely deteriorated. Operating cash flow fell from 18% to 11% of revenue while net income stayed at 10%, so cash backing of earnings dropped from 1.8 times to 1.1 times. The steady margin hides this weakening in cash conversion.

  1. Aimproved, because operating cash flow still exceeds net income
  2. Bdeteriorated, because the cash conversion of earnings weakenedCorrect
  3. Cis unchanged, because net income margin was steady

Explanation

Operating cash flow relative to net income fell from 1.8 times to 1.1 times, so less of the reported earnings is backed by cash. The level still exceeding net income does not mean improvement since the trend is down. A steady margin does not show stable cash conversion.

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