Chartered Financial Analyst (CFA) Level 1 Practice Exam

Which metric is likely to be distorted by non-cash expenses, impacting the EPS measurement?

1. Basic EPS

2. Diluted EPS

3. Return on Equity (ROE)

4. Price to Cash Flow (PC/F)

The correct answer is: Basic EPS

The basic earnings per share (EPS) metric is directly influenced by net income, which is derived from a company’s income statement. Non-cash expenses, such as depreciation and amortization, reduce net income but do not affect cash flow. This reduction in net income means that basic EPS, which is calculated by dividing net income by the weighted average shares outstanding, can be distorted as non-cash expenses can lead to a lower reported net income. This results in a potentially misleading picture of a company's actual financial performance, especially if stakeholders do not consider those non-cash adjustments. In contrast, diluted EPS accounts for all potential dilutive securities, which may not inherently distort due to non-cash expenses but rather focus on the impact of possible share dilution. Return on Equity (ROE) measures profitability as a percentage of shareholders' equity and may also consider non-cash items, but its focus is on return relative to equity rather than EPS specifically. Price to Cash Flow (PCF) uses cash flow generated rather than net income, and thus is not affected by non-cash expenses in the same way that EPS is. This understanding is crucial for analyzing the impact of accounting practices on financial statements, especially in decision-making or valuation processes.