paper 2 analysing financial performance

a level business eduqas

Explain what is meant by a budget variance

Budget variance = difference between budgeted and actual financial performance.

Favourable vs adverse:

Favourable (F) = actual performance is BETTER than budgeted.
Adverse (A) = actual performance is WORSE than budgeted.

	Favourable ✅	Adverse ❌
Revenue	Actual > budget	Actual < budget
Costs	Actual < budget	Actual > budget

Memory rule:
Revenue → more = favourable
Costs → less = favourable

Example:
Budgeted costs = £50k; actual costs = £45k → £5k favourable variance.

Calculate budget variances

formula : Variance = Actual − Budgeted

Then decide whether it is F or A:

Revenue

• Actual > budget → Favourable

• Actual < budget → Adverse

Costs

• Actual < budget → Favourable

• Actual > budget → Adverse

Always state the £ variance AND whether it is F/A.

Analyse budgets and budget variances

Favourable variance: Better than budgeted, but investigate why.

• Favourable revenue variance → revenue higher than expected → potentially higher profit.

• Favourable cost variance → costs lower than expected → potentially higher profit.

Adverse variance: Worse than budgeted, so investigate the cause.

• Adverse revenue variance → revenue lower than expected → potentially lower profit.

• Adverse cost variance → costs higher than expected → potentially lower profit.

Possible causes

• Changes in demand

• Inaccurate forecasts

• Price changes

• Input-cost changes

• Inflation

• Inefficiency/productivity changes

• Unexpected external factors

Large/unusual variances should be investigated rather than automatically assuming performance is good/bad.

Evaluate the use and impact of budgets and budget variances for a business and its stakeholders

Benefits of budgets

• Targets → can motivate employees/managers.

• Financial control → actual vs planned performance.

• Early identification of problems → corrective action.

• Planning → helps allocate resources.

• Performance measurement → assesses departments/managers.

• Coordination → different areas work towards common objectives.

Limitations

• Forecasts may be inaccurate → unrealistic budgets.

• External changes can make budgets outdated.

• Unrealistic targets → employee demotivation.

• Managers may focus on short-term targets → long-term objectives neglected.

• May encourage budget manipulation.

• Preparation can be time-consuming/costly.

• A variance shows a difference but does not automatically explain why it occurred.

Stakeholder impact

• Managers: control + performance measurement; may face pressure.

• Employees: clear targets/motivation; unrealistic targets may demotivate.

• Shareholders: effective control may improve profit/returns.

• Lenders: budgets can indicate ability to meet financial commitments.

• Suppliers: financial strength affects confidence in payment.

Evaluation: usefulness depends on forecast accuracy, quality of information and changing external conditions.

Explain the main components of a balance sheet and the way that it is constructed

Balance sheet = snapshot of a business's financial position at a particular date.

Non-current assets: Assets held for long-term use. Examples: property, machinery, vehicles. Usually recorded at net book value after depreciation.

Current assets: Assets expected to be converted into cash within a short period. Examples: inventory, trade receivables, cash.

Current liabilities: Amounts owed due within a short period. Examples: trade payables, overdraft, short-term borrowing.

Non-current / long-term liabilities: Debt due after more than one year. Example: long-term loans.

Shareholders' capital: Finance provided by shareholders + retained profits/reserves.

Construction:

Working capital = Current assets − Current liabilities

Net assets = Total assets − Current liabilities

Capital employed = Shareholders' capital + long-term liabilities

Capital employed = Net assets

Therefore:

Total assets = Total liabilities + shareholders' capital

The balance sheet must balance.

Explain what is meant by working capital, capital employed and depreciation

Working capital: Working capital = Current assets − Current liabilities →Funds available for day-to-day operations.

Capital employed: Long-term finance invested in the business.

Capital employed = Shareholders' capital + long-term liabilities

OR

Capital employed = Non-current assets + working capital

Depreciation: Reduction in the value of a non-current asset over time due to use, wear and tear, age or obsolescence.

Calculate working capital, capital employed (long-term liabilities and shareholders’ capital) and depreciation (the straight line method only)

Working capital: Current assets − Current liabilities

Capital employed: Shareholders' capital + long-term liabilities OR Non-current assets + working capital

Straight-line depreciation: Annual depreciation = (Cost − Residual value) ÷ Useful life

Net book value = Original cost − Accumulated depreciation

Important: depreciation reduces accounting profit and asset value, but is not a cash outflow when recorded.

interpret and analyse a balance sheet

Look at:

• Working capital → ability to fund day-to-day operations.

• Liquidity → ability to meet short-term liabilities.

• Capital employed → amount of long-term finance invested.

• Non-current assets → resources committed long term.

• Current assets → short-term resources.

• Liabilities → financial obligations.

• Shareholders' capital → owners' finance

Analysis Figure → meaning → cause → consequence

Example:

Falling working capital → less short-term financial flexibility → greater risk of difficulty paying liabilities → potential cash-flow problems.

Always compare with previous years and other businesses.

Calculate and interpret return on capital employed (ROCE)

ROCE = Operating profit ÷ Capital employed × 100

Measures the return generated from long-term capital invested.

Interpretation

• Higher ROCE → more operating profit generated per £ of capital employed.

• Rising ROCE → improving return relative to capital employed.

• Falling ROCE → declining return.

Possible causes:

• Operating profit changes.

• Capital employed changes.

• Both.

Compare with previous years and other businesses.

Calculate and interpret the current ratio and acid test ratio

Current ratio = Current assets ÷ Current liabilities

Measures ability to meet short-term liabilities using current assets.

• Higher → generally stronger liquidity.

• Very low → greater risk of difficulty paying short-term debts.

• Very high → resources may be tied up inefficiently.

Acid test ratio = (Current assets − Inventory) ÷ Current liabilities

More stringent liquidity measure because inventory may not be quickly converted into cash.

• Higher → stronger immediate liquidity.

• Low → greater dependence on selling inventory to meet liabilities.

Context matters: there is no universally ideal ratio for every business.

Calculate and interpret the gearing ratio (long-term liabilities/capital employed)

Gearing ratio = Long-term liabilities ÷ Capital employed × 100

Measures the proportion of capital employed financed by long-term debt.

High gearing

• Greater reliance on debt.

• Higher interest/repayment obligations.

• Greater financial risk.

• But debt can finance expansion without issuing additional shares.

Low gearing

• Less reliance on debt.

• Lower interest/financial risk.

• But potentially less use of debt to finance growth.

Compare over time + with other businesses/industry.

Analyse the trading, profit and loss account (the income statement) and the balance sheet in order to assess the financial performance of a business

Income statement

Revenue → sales generated.

Gross profit → profit after cost of sales.

Gross profit margin → profitability of trading activity.

Operating profit → profit after operating expenses.

Operating profit margin → profitability after operating expenses.

Look for changes/trends.

Balance sheet

Working capital → short-term financial position.

Current ratio/acid test → liquidity.

Gearing → financial risk/dependence on debt.

Capital employed → long-term finance invested.

Strong analysis chain

Financial result → what it indicates → why → impact on business/stakeholders

Example:

ROCE falls → less operating profit generated per £ invested → profitability/efficiency may have deteriorated → lower potential returns for shareholders.

Consider business accounts in relation to previous years and other businesses

Previous years

Look for trends, not isolated figures.

Ask:

• Is revenue rising/falling?

• Are profit margins improving?

• Is ROCE rising/falling?

• Is liquidity improving?

• Is gearing increasing/decreasing?

• Is working capital changing?

Other businesses

Use ratios/percentages rather than absolute figures.

Consider differences in:

• Size

• Industry

• Business model

• Capital intensity

• Age/growth stage

• Accounting methods

Key principle: a financial figure/ratio only has meaning when placed in context.

Evaluate the financial position of a business

Assess profitability + liquidity + financial risk + long-term financial position together.

A business can be:

• Profitable but illiquid → profit does not guarantee enough cash to pay short-term debts.

• Liquid but unprofitable → able to pay debts but potentially poor long-term performance.

• Highly profitable but highly geared → strong returns but greater financial risk.

• Strong currently but deteriorating → current figures alone may hide a negative trend.

Evaluation structure

Evidence → interpretation → comparison/context → limitation → overall implication

Use:

• Previous years

• Competitors

• Industry norms

• Business objectives

• External factors

Never reach a conclusion from one ratio/figure alone.

Understand that accounts can be affected by window-dressing and other factors, such as changes in demand and inflation

Window dressing

Window dressing = presenting/manipulating accounts to make financial performance or financial position appear better than it actually is.

Therefore:

• Accounts may give a misleading impression.

• Stakeholders may make decisions using distorted information.

• Comparisons may become less reliable.

Changes in demand

Higher demand → potentially higher sales/revenue/profit.

Lower demand → potentially lower sales/revenue/profit.

Therefore changes in demand can alter:

• Revenue

• Profit

• Margins

• Liquidity

• Ratios

Inflation

Inflation can:

• Increase input costs.

• Increase selling prices.

• Affect revenue and profit.

• Make year-on-year comparisons misleading because higher figures may reflect price increases rather than real growth.

• Affect the value of assets and depreciation.