Free CFA Level I Financial Statement Analysis Practice Questions

The fundamental accounting equation is Assets = Liabilities + Owners' Equity. Every transaction affects this equation while keeping it in balance. Choice B confuses the income statement relationship (Revenue − Expenses = Net Income) with the balance sheet.
Choice C is incorrect because Assets − Liabilities equals Owners' Equity (net worth), not net income. Net income is a flow concept from the income statement that feeds into retained earnings on the balance sheet.

FCFF represents cash available to all capital providers (debt and equity holders). Starting from net income: FCFF = NI + Non-cash charges (e.g., depreciation) + Interest expense × (1 − t) − Changes in working capital − Capital expenditures. Adding back after-tax interest is necessary because net income is after interest expense, but FCFF is a pre-financing measure. Choice B omits the after-tax interest add-back, calculating free cash flow to equity (FCFE) instead.
Choice C is incorrect because dividends are a distribution to equity holders, not a deduction in calculating FCFF, and it double-counts some items.

During inflation, FIFO produces the lowest COGS (oldest, cheapest units sold first) and highest ending inventory, while LIFO produces the highest COGS and lowest ending inventory. Weighted average cost yields COGS and ending inventory values between these two extremes because it blends old and new costs.
Choice A is incorrect because weighted average COGS would be higher than FIFO (not lower) during inflation. Choice C is partially correct in direction but overstates the effect; weighted average COGS is higher than FIFO but lower than LIFO, and ending inventory is lower than FIFO but higher than LIFO.