Chartered Financial Analyst (CFA) Level 1 Practice Exam

What do higher profitability ratios indicate about a company?

1. Increased risk of bankruptcy

2. Improved cost management

3. Stronger competitive position

4. Greater revenue growth

The correct answer is: Stronger competitive position

Higher profitability ratios suggest that a company is able to generate more profit per dollar of revenue or investment, which can be an indicator of a stronger competitive position within its industry. These ratios, which include metrics such as net profit margin, return on assets, and return on equity, reflect the efficiency with which a company is managing its operations and expenses relative to its sales or investment base. A strong profitability ratio often implies that the company has effective pricing strategies, superior cost control measures, or a unique product offering that differentiates it from competitors. As such, it can maintain or even increase its margins, making it less susceptible to competitive pressures. This stronger competitive position could allow the company to attract more customers, retain existing ones, and potentially command higher prices for its goods or services. In contrast, increased risk of bankruptcy typically relates more to ratios that assess financial leverage and solvency, such as the debt-to-equity ratio, rather than pure profitability metrics. Improved cost management might lead to higher profitability ratios but is not the sole indicator. Greater revenue growth is important for a company's success, but the relationship between revenue growth and profitability is not always direct; a company can grow revenues without improving profitability ratios, especially if it incurs high costs in the process.