Financial Analysis: Variance, Ratios, and Cash Flow Judgment
What you must understand
Financial analysis on FPAC Part II rewards the ability to move between three lenses: variance analysis (why results differ from plan), ratio analysis (how the business is structured), and cash flow quality (whether reported profit converts to cash). Know the variance decomposition: total variance = price/rate variance + volume/efficiency variance, and remember the sign convention - a favorable variance increases operating income relative to budget, regardless of whether the underlying item is revenue or cost. For ratios, be fluent in liquidity (current, quick), leverage (debt-to-equity, interest coverage), profitability (gross, operating, net margin), and activity (inventory turns, days sales outstanding, days payable outstanding). Understand the cash conversion cycle = DSO + days inventory outstanding − DPO, and that shortening it releases working capital.
Traps candidates fall into
- Mixing up static and flexible budgets: volume variances must be computed on the flexible budget, or the analysis double-counts volume as price.
- Treating a favorable cost variance as always good - over-purchasing for a quantity discount can raise holding costs and hurt cash.
- Using year-end balances for ratios when average balances are appropriate (inventory, receivables).
- Confusing operating cash flow with free cash flow (OCF minus capital expenditures).
- Ignoring that a rising current ratio driven by inventory build is a warning, not strength.
Worked example / rule of thumb
Budget: 10,000 units at $50 = $500,000 revenue; actual: 9,500 units at $52 = $494,000. Revenue variance = −$6,000 (unfavorable). Price variance = (52 − 50) × 9,500 = +$19,000 favorable; volume variance = (9,500 − 10,000) × 50 = −$25,000 unfavorable. Sum: −$6,000. Rule of thumb: always prove the decomposition back to the total variance before selecting an answer.