F2: Analysing statements

Answer: A. ROCE = EBIT ÷ capital employed = £300,000 ÷ £1,500,000 = 0.20 = 20%. Capital employed is typically defined as total assets minus current liabilities (or non-current assets plus net working capital). Common errors: using profit after tax instead of EBIT (which would include the financing decision); dividing capital employed by EBIT (£1,500,000 ÷ £300,000 = 5, not a ratio but a turnover multiple); or applying an incorrect numerator. 5% expresses that multiple as a percentage, and 25% and 15% do not follow from the figures.

Answer: B. Debt-to-equity gearing = long-term debt ÷ equity = £400,000 ÷ £600,000 = 66.7%. This is one common definition; the debt-to-total-capital variant would be £400,000 ÷ £1,000,000 = 40%. The 160% figure would arise from inverting the ratio (£600,000 ÷ £400,000 ≈ 150%, not 160%). The 28.6% arises from another incorrect formula. Higher gearing increases financial risk since debt carries fixed interest obligations regardless of profit.

Answer: C. Interest cover = EBIT ÷ finance costs = £300,000 ÷ £40,000 = 7.5 times. This means operating profit covers the interest charge 7.5 times, indicating the company can comfortably service its debt from current earnings. A lower ratio indicates higher financial risk. The 7.5% figure confuses the ratio with a percentage and inverts the formula. The 0.13 figure is the inverse (£40,000 ÷ £300,000). The answer of 40 miscalculates entirely.

Answer: D. Current ratio = current assets ÷ current liabilities = £360,000 ÷ £240,000 = 1.5. Quick ratio = (current assets − inventory) ÷ current liabilities = (£360,000 − £120,000) ÷ £240,000 = £240,000 ÷ £240,000 = 1.0. The quick ratio excludes inventory since it is the least liquid current asset. Common errors: forgetting to exclude inventory for the quick ratio; dividing by current assets instead of liabilities; or using the wrong subtraction order.

Answer: A. Inventory days = inventory ÷ cost of sales × 365 = £150,000 ÷ £900,000 × 365 = 60.8 days. Receivables days = trade receivables ÷ revenue × 365 = £180,000 ÷ £1,200,000 × 365 = 54.8 days. Common error: using revenue as the denominator for inventory days (should be cost of sales, since inventory is held at cost). Receivables are compared to revenue since they arise from credit sales. The options 45.6 and 60.8 for receivables arise from using incorrect denominators.

Answer: B. Net profit margin = profit after tax ÷ revenue = £180,000 ÷ £1,200,000 = 0.15 = 15%. Asset turnover = revenue ÷ total assets = £1,200,000 ÷ £2,000,000 = 0.6 times. Together these link to ROCE via the DuPont identity: ROCE = net profit margin × asset turnover (though this typically uses EBIT in the numerator). The 9% arises from dividing profit by assets. The 1.7 times asset turnover arises from dividing assets by revenue (£2,000,000 ÷ £1,200,000), which inverts the formula.

Answer: C. P/E ratio = share price ÷ EPS = 300p ÷ 25p = 12. Dividend yield = DPS ÷ share price = 15p ÷ 300p = 5.0%. The P/E of 8.3 arises from dividing EPS by share price (25 ÷ 300), inverting the formula. The dividend yield of 6.0% might arise from dividing by EPS rather than share price. The P/E of 20 would arise from an EPS calculation error (e.g. 300 ÷ 15 = 20, mistakenly using DPS rather than EPS).

Answer: D. Ratio analysis uses historical data from financial statements, which reflects past conditions rather than current or future performance — particularly problematic in rapidly changing environments. Ratios can also be distorted by different accounting policies (e.g. different depreciation methods or revaluation approaches), making cross-company comparisons unreliable unless policies are reconciled. A higher ROCE can reflect lower capital investment rather than better management, and comparisons must account for industry norms and capital structure differences. Ratios do not forecast reliably — they describe, not predict.

Answer: A. A falling current ratio from 2.1 to 1.4, combined with falling below the industry average of 1.6, suggests deteriorating short-term liquidity. This warrants investigation — possible causes include extending supplier credit, faster cash collection from customers, or rising short-term debt. Context matters: a ratio of 1.4 may be adequate in some industries (e.g. supermarkets with fast inventory turnover) but insufficient in others. The industry average provides a useful benchmark; ignoring it removes important context. A lower ratio can reflect efficiency, but the trend and gap versus peers here suggest deterioration rather than deliberate working capital improvement.

Answer: B. Earnings yield = EPS ÷ share price = 1 ÷ P/E, expressing the return implied by the current earnings relative to the share price. At 8.3%, it exceeds the 4% risk-free rate, reflecting the equity risk premium — compensation investors require for bearing the additional risk of equity ownership versus a risk-free asset. Earnings yield is not a guaranteed return; actual shareholder returns depend on future earnings, dividends and capital gains. A yield below the risk-free rate might indicate expectations of strong growth (growth valued in the price), not necessarily immediate overvaluation. Earnings yield is deeply connected to required returns and risk.

Answer: C. Group ROCE averages across segments of potentially very different scale, risk and profitability. A 16% group average masks the fact that Segment A significantly outperforms (25%) while Segment B substantially underperforms (8%), possibly earning below its cost of capital. Investors and managers need segmental data to make informed capital allocation decisions, assess divisional management, and evaluate whether underperforming segments should be improved or divested. The average is not the whole story; segment-level analysis matters precisely because averages can obscure important differences.

Answer: D. Payables days = trade payables ÷ cost of sales × 365 = £100,000 ÷ £900,000 × 365 = 40.6 days. An increase in payables days may indicate the company is extending the time it takes to pay suppliers — potentially a sign of cash flow pressure if suppliers are not voluntarily offering longer terms. It can also reflect deliberate working capital management. Using revenue instead of cost of sales gives £100,000 ÷ £1,200,000 × 365 = 30.4 days (incorrect, as payables relate to purchases, which align with cost of sales). Payables are never divided by total assets in this calculation.

Answer: A. ROCE = EBIT margin × asset turnover. If EBIT margin is unchanged, a decline in ROCE must be entirely attributable to a fall in asset turnover — the company is generating less revenue per pound of capital employed (perhaps due to asset expansion not matched by revenue growth, or slower revenue growth). Tax rate does not affect ROCE (which uses EBIT, a pre-tax measure). Cost of equity affects the hurdle rate but not the measured ROCE itself. Dividend payout affects equity reserves but not EBIT or capital employed in a way that directly changes asset turnover.

Answer: B. NAV per share = total equity ÷ shares = £6,000,000 ÷ 4,000,000 = £1.50. Market price typically differs from NAV because markets price shares based on future earnings, growth prospects, and value of intangibles (brand, customer relationships) not reflected in the balance sheet. In an efficient market, price reflects future expectations, not just current net assets. The £4.00 figure inverts the formula. The £6.00 takes total equity with no division. Even in efficient markets, price and NAV routinely diverge — that divergence is economically meaningful.

Answer: C. Repaying the loan before year-end reduces current liabilities, which increases the current ratio (current assets ÷ current liabilities) at the reporting date. Since the loan is immediately redrawn after year-end, the reported ratio does not reflect the ongoing liquidity position — this is classic window dressing. It is not a required treatment under any accounting standard; it is a deliberate timing of a financial transaction to present a more favourable ratio. This limitation of ratio analysis — that period-end balances can be managed — is a key reason why trend analysis and understanding of the business are important supplements to ratio calculation.

Answer: C. Cash conversion cycle = inventory days + receivables days − payables days = 60 + 55 − 40 = 75 days. This measures the time between paying for goods (when payables are settled) and receiving cash from customers. A shorter CCC is generally better as it means cash is tied up for less time. The 115 days figure adds all three without subtracting payables. The 40 days figure uses payables days alone. The 155 days sums all three without any subtraction.

Answer: D. Debt-to-total capital = debt ÷ (debt + equity) = £600,000 ÷ (£600,000 + £900,000) = £600,000 ÷ £1,500,000 = 40%. This is an alternative gearing definition from debt-to-equity. Debt-to-equity would give £600,000 ÷ £900,000 = 66.7%. The 60% figure arises from inverting numerator and denominator or using equity in the numerator. The 150% would result from reversing equity and debt in the debt-to-equity formula.

Answer: A. Dividend cover = EPS ÷ DPS = 30p ÷ 12p = 2.5 times. This shows how many times earnings cover the dividend paid — a cover of 2.5 means the company could pay the current dividend 2.5 times from current earnings, suggesting headroom for both the dividend and retained earnings. The 0.4 times figure is the payout ratio (DPS ÷ EPS = 12 ÷ 30), which is the inverse. The 18p is the retained earnings per share (30p − 12p), not the dividend cover. A cover below 1.0 would mean dividends exceed earnings. 2.0 times does not follow from the figures.

Answer: B. Enterprise value = market capitalisation + net debt − cash = £800m + £200m − £50m = £950m. EV/EBITDA = £950m ÷ £120m = 7.92 ≈ 7.9 times. EV represents the total value of the business to all capital providers and is used as a valuation metric. The £1,000m figure omits the cash deduction (£800m + £200m). The £800m uses only market cap. The £1,050m adds cash rather than deducting it. EV/EBITDA is widely used for comparing valuations across companies with different capital structures since it is pre-debt, pre-tax and pre-depreciation.

Answer: C. ROE = profit after tax ÷ equity = £180,000 ÷ £1,000,000 = 18%. ROE reflects the return earned for equity holders after debt costs. When the return on capital employed exceeds the cost of debt (positive financial gearing), ROE will exceed ROCE — gearing amplifies returns to equity. ROE and ROCE are not identical when gearing is present; they converge only in an all-equity company. ROE uses equity, not total assets, as the denominator. And ROE can be higher or lower than ROCE depending on whether gearing is beneficial or destructive.

Answer: D. Sustainable growth rate = ROE × retention ratio = ROE × (1 − payout ratio) = 18% × (1 − 40%) = 18% × 60% = 10.8%. This is the rate at which a company can grow using only retained earnings — without changing its capital structure or issuing new equity. Using just the ROE (18%) ignores the payout constraint. The 7.2% figure might arise from ROE × payout ratio (18% × 40%), using the wrong retention factor. The 4.5% could result from a calculation error. Retention ratio = 1 − dividend payout ratio.

Answer: B. PEG ratio = P/E ÷ expected earnings growth rate. Company A: 25 ÷ 20 = 1.25. Company B: 18 ÷ 6 = 3.0. Company A has the lower PEG. A PEG below 1.0 is sometimes considered undervalued; here A (1.25) appears better value relative to its growth than B (3.0), even though A has a higher P/E, because A's growth rate compensates for the premium. A lower P/E does not automatically mean a lower PEG — the growth rate is the key additional variable. PEG ratios differ across companies regardless of listing status.

Answer: C. While a current ratio above 1.0 is generally considered healthy from a liquidity perspective, an excessively high ratio may mean the company is holding too much cash (earning little return), carrying excess inventory (with associated holding costs) or allowing receivables to build up rather than collecting promptly. These tie up capital that could be deployed more productively. The optimal level balances liquidity risk against the opportunity cost of holding liquid but low-return assets. A ratio above 2.0 is not automatically excellent; it depends on the business and industry norms. The ratio becomes critical (but not only then problematic) when below 1.0.

Answer: C. Under the revaluation model, asset values (and hence capital employed) are higher than under cost model, mechanically reducing ROCE even if underlying trading performance is identical. When comparing companies using different PP&E measurement models, the analyst must be aware that reported ROCE differences may reflect accounting policy choices rather than genuine operational differences. IFRS permits either the cost or revaluation model, so it is not the case that both companies must use the same policy. The direction of the effect (higher revaluation → higher capital → lower ROCE) is consistently as described.

Answer: D. Rising receivables days means customers are taking longer to pay. This can arise from deliberate policy changes (extending credit terms to attract or retain customers) or operational deterioration (poor credit control, disputes, or customers in financial difficulty). It is not a sign of tighter credit policy — that would reduce receivables days by collecting faster. Growing revenue can coexist with rising receivables days if the credit period is also extending. The interpretation requires context: deliberate policy relaxation may be commercially rational, while deterioration in collections is a red flag.

Answer: A. Diluted EPS assumes the exercise of all potentially dilutive instruments — such as share options (typically at zero or below-market cost to holder) and convertible bonds (adding shares to the denominator and interest saved to the numerator). The net effect is a larger share count (diluted denominator), which generally reduces EPS. This makes diluted EPS a more cautious measure — it shows the EPS available to shareholders if all dilutive potential shares were issued. Diluted EPS is by definition not higher than basic EPS (anti-dilutive instruments are excluded). Preference dividends affect both similarly.

Answer: C. Total shareholder return (TSR) = dividend yield + capital gain = 3% + 8% = 11%. TSR captures the full return received by shareholders: cash income from dividends plus the change in the value of their investment. It is a comprehensive return measure widely used in executive remuneration benchmarks. Counting only capital gains ignores the dividend component. Counting only dividends ignores capital appreciation. Subtracting one from the other (5%) has no financial meaning in this context.

Answer: A. When a company is growing, receivables and inventory typically increase — representing cash that has been committed to operating the business but not yet collected. This is the most common cause of operating cash flow lagging behind profit in a growing business. Depreciation actually reduces profit relative to cash (it is a non-cash charge added back in the cash flow statement). Tax reduces both cash and profit. Interest received increases both cash and profit in most cases. The working capital build-up scenario — profit growing but cash lagging — is a classic financial analysis red flag that can precede liquidity problems if unchecked.

Answer: B. ROCE = EBIT margin × asset turnover. If asset turnover falls from 1.2 to 0.9 while margin is unchanged, then ROCE falls proportionally: if margin were 20%, ROCE would fall from 24% (20% × 1.2) to 18% (20% × 0.9). A declining asset turnover means the company generates less revenue per pound of assets — either because assets have grown faster than revenue, or revenue has fallen. ROCE is therefore directly affected by asset turnover changes. ROCE does not remain unchanged simply because margin is steady.

Answer: A. Gross profit margin = gross profit ÷ revenue. If revenue is flat but gross margin falls, gross profit has declined, which means cost of sales has increased. The most likely culprits are: input cost inflation (rising raw material or labour costs in production); deteriorating purchase terms; or a shift in product mix towards lower-margin items. Administrative expenses sit below gross profit — they affect operating margin but not gross margin. Finance costs reduce profit below operating level, not gross profit. Corporation tax rates affect post-tax profit and EPS but not gross profit at all.

Answer: B. Within the same industry, a large P/E premium usually reflects differing growth expectations. Company B's P/E of 25 suggests the market anticipates significantly faster earnings growth, justifying paying a higher multiple of current earnings for a share of future profits. Company A at P/E 8 may be a mature, slower-growing business where earnings are stable but not expected to increase rapidly. A high P/E does not automatically mean overvalued — it may be rational given expected growth. A low P/E does not guarantee outperformance. Dividend policy affects payout not the P/E's primary driver in a growth context.

Answer: C. Horizontal analysis (trend analysis) compares financial data across multiple periods — typically two to five years — to identify trends in absolute amounts and percentage changes for items such as revenue, costs, profit, and key ratios. This helps identify whether performance is improving, deteriorating, or cyclical over time. Comparing against industry peers is cross-sectional (peer) analysis. Calculating line item proportions within a single period is vertical (common-size) analysis. Comparing subsidiaries to parents is a different type of internal analysis, not horizontal analysis.

Answer: D. In inventory management, ABC analysis classifies items by their total annual value (not unit count): category A items are high-value, often representing around 70–80% of total inventory value while being only 10–20% of lines — these warrant tight control and frequent review. Category B items are medium-value. Category C items are many in number but low in individual value — less intensive control is cost-effective here. This avoids spending equal management effort on both expensive and trivial items. The activity-based costing technique is a separate concept (also called 'ABC', confusingly). The customer credit and audit contexts are different ABC classifications.

Answer: A. When profit grows much faster than operating cash flow, the gap is often explained by: increasing accruals (revenue recognised before cash is received); working capital build-up (growing receivables or inventory absorb cash); or non-cash income items. This divergence raises earnings quality concerns — the reported profit may not be backed by equivalent cash flows, making it less sustainable. Sophisticated analysts often regard operating cash flow as a purer indicator of underlying performance. Profit growing faster than cash is not automatically positive — it is a key warning sign that warrants further investigation. Cash flow is central to earnings quality analysis.

Answer: B. Listed company share prices reflect investor expectations about future earnings, dividends and growth. They also incorporate value from intangible assets — such as brand strength, proprietary technology, customer loyalty and management capability — that IFRS prevents from recognising on the balance sheet unless acquired in a business combination. Book value records historical costs (less depreciation) and is thus typically lower than market value for successful, growing companies. Efficient market theory does not imply market equals book value — it implies prices reflect available information, which includes growth prospects beyond book assets. Book exceeds market value only in distressed situations.

Answer: C. Overtrading occurs when a business grows so rapidly that its working capital becomes insufficient to support the increased activity. Indicators include: deteriorating current ratio (working capital stretched); rising receivables days (collecting too slowly); falling payables days (being pressured to pay suppliers faster); and cash shortages. The company may be profitable on paper but face a cash flow crisis because the growth is consuming cash faster than it is generated. This is distinct from over-capitalisation (too much equity) or conservative working capital management (which would show opposite trends). It is not a liquidity strength signal.

Answer: A. Degree of operating leverage = contribution ÷ operating profit = (£1,000,000 − £500,000) ÷ £200,000 = £500,000 ÷ £200,000 = 2.5. This means a 1% change in revenue produces approximately a 2.5% change in operating profit (in the same direction). High fixed costs amplify the effect of revenue changes on profit. The DOL of 2.0 would arise from using the wrong contribution figure. The 0.4 figure inverts the formula (profit ÷ contribution). The 5.0 figure might arise from using total costs rather than contribution in the numerator.