Financial Analysis

Comprehensive practice questions and answers covering ratios, formulas, interpretation techniques, and financial statement analysis based on the revision notes.

How is financial analysis defined in these notes?

The use of information from annual reports to judge a company's financial performance, financial position, risk and investment potential.

What are the four key areas of focus in financial analysis beyond simple ratio calculation?

Performance (income statement and profitability), Position (statement of financial position and liquidity/gearing), Investor view (returns and market confidence), and Underlying performance (core performance after exceptional items).

In the context of financial analysis, what does a calculation on its own represent?

A calculation on its own is not analysis; analysis requires explaining what the number suggests, why it changed, whether it is good or bad, and what extra information is needed.

What is the formula for Gross profit margin?

$$\frac{\text{Gross profit}}{\text{Revenue}} \times 100$$

What is the formula for Operating profit margin?

$$\frac{\text{Operating profit (PBIT)}}{\text{Revenue}} \times 100$$

What is the formula for Return on equity (ROE/ROSF)?

$$\frac{\text{Profit after tax}}{\text{Equity}} \times 100$$

How is Return on capital employed (ROCE) calculated?

$\frac{\text{Operating profit (PBIT)}}{\text{Capital employed}} \times 100$, where Capital employed is commonly $\text{equity} + \text{non-current liabilities/long-term loans}$.

What is the formula for the Current ratio?

$$\frac{\text{Current assets}}{\text{Current liabilities}}$$

What is the formula for the Acid test (quick) ratio?

$$\frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$$

What are the common guide ranges for the Current ratio and Acid test ratio?

Current ratio: around $1.5$ to $2:1$; Acid test ratio: around $1:1$.

What is the formula for Capital gearing?

$$\frac{\text{Long-term loans or NCL}}{\text{Equity} + \text{long-term loans or NCL}} \times 100$$

What is the formula for Interest cover?

$$\frac{\text{PBIT}}{\text{Interest payable}}$$

What is the formula for Earnings per share (EPS)?

$$\frac{\text{Profit attributable to ordinary shareholders}}{\text{weighted average ordinary shares}}$$

What is the formula for Dividend cover?

$\frac{\text{EPS}}{\text{DPS}}$ or $\frac{\text{Profit after tax}}{\text{Dividends paid}}$

What is the formula for Dividend yield?

$$\frac{\text{DPS}}{\text{Share price}} \times 100$$

What is the formula for the Price/Earnings ratio (P/E)?

$$\frac{\text{Share price}}{\text{EPS}}$$

What is the formula for Earnings yield?

$$\frac{\text{EPS}}{\text{Share price}} \times 100$$

How is Market capitalisation calculated?

$$\text{Share price} \times \text{Number of ordinary shares in issue}$$

Why might Market capitalisation be higher than the book value of equity?

It may reflect expected future earnings, strong brands, growth potential, or unrecognised assets like reputation and human resources which are not recorded under historical cost accounting.

What is the formula for Inventory days?

$$\frac{\text{Average inventory}}{\text{Cost of sales}} \times 365$$

What is the formula for Receivables days?

$$\frac{\text{Average trade receivables}}{\text{Credit sales}} \times 365$$

What is the formula for Payables days?

$$\frac{\text{Average trade payables}}{\text{Purchases or cost of sales}} \times 365$$

What is the difference between headline profit and underlying/adjusted profit?

Headline profit is the reported figure, while underlying profit removes exceptional and non-recurring items (like restructuring or one-off gains) to show core trading performance.

What is the 'exam rule of thumb' for deciding whether to exclude an item from underlying performance?

Exclude items that are unusual, non-recurring, and not part of trading; usually include items like brand marketing and R&D if they relate to normal current-year operations.

What are the six steps in the recommended structure for writing ratio interpretation?

1. State the movement; 2. Explain what it means; 3. Suggest causes; 4. Add caution or context; 5. Compare (competitors/industry); 6. Conclude.

What are three common limitations of ratios and financial statements?

They are historical and out of date, they suffer from the 'snapshot problem' (year-end only), and they do not show non-financial information like customer loyalty or staff quality.

What common mistake should be avoided regarding ROCE in an exam?

Using profit after tax instead of operating profit (PBIT) for the calculation.

What are the figures needed to calculate Sales to capital employed?

$$\frac{\text{Revenue}}{\text{Capital employed}}$$

What can a high P/E ratio suggest to an analyst?

Market confidence and growth expectations, or potential overvaluation.

Why is segmental analysis useful in financial evaluation?

It helps identify which specific products, business segments, or geographical markets are driving revenue and profit growth or carrying the most risk.