CFA Practice Question

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CFA Practice Question

Consider the following statement: A firm that earns negative net income will quickly find itself in financial distress.

I. This statement is false because it is possible for a firm to have negative profits but still have positive cash flows.
II. This statement is false because accounting profits do not generally equal cash flow and it is a lack of cash, not profits, that causes financial distress.
III. This statement is true because negative profits mean negative cash flows.
Correct Answer: I and II

User Contributed Comments 5

User Comment
samreen911 hi can somebody explain
SKIA A company can have positive cash flow and negative profits if it has a lot of items in expense that are non-cash, e.g. depreciation, prepaid expenses, losses on bad debt, etc. all reduce accounting income; however, they do not reduce cash flows. Hope that helps!
vadfir I agree with I and II, but wanted to clarify: Doesn't prepaid expense reduce or increase cash flow, similar to A/R?
andsko Yes. It's cash going out so it definetely reduces CF. CF is always about does cash leave or come in basically. So if you have prepaid expenses you have transfered money and thereby it affects CF.
ascruggs92 Truly, the key word here is "quickly." A company can be cash flow positive with negative earnings, and it can do this for years on end. However, a lack of accounting profit indicates that the company is generating a negative return on investment, and while it will take some time, the company will find itself in financial distress
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