Finance and investment: financial statements, ratios, sources of finance, investment appraisal
Domain 5 - Finance and investment
Two question families dominate: interpreting financial statements and ratios, and appraising an investment. Ratio answers earn marks for the formula plus the interpretation of what the number means, not the figure alone.
Core rules and concepts
- Balance sheet identity: assets = liabilities + equity. Equity is the owners' residual claim, not a liability.
- Working capital = current assets − current liabilities; a negative figure signals liquidity pressure.
- Ratios: current ratio = current assets / current liabilities; quick ratio excludes inventory; debt-to-equity = liabilities / equity; ROE = net profit / equity; ROA = net profit / total assets; net margin = net profit / sales.
- Interpretation: compare with the sector and with the firm's own history; one ratio in isolation means nothing.
- Sources of finance: internal (retained earnings); short-term external (overdraft, supplier credit, factoring); long-term external (bank loan, bonds, share issue, leasing, venture capital, crowdfunding, public grants).
- Appraisal: NPV = Σ CFt/(1+r)^t − initial outlay; accept if positive. IRR is the discount rate giving NPV = 0; accept if IRR exceeds the cost of capital. Payback ignores the time value of money and all cash flows after the cut-off.
Worked example
Outlay €100,000; inflows €40,000 (year 1), €50,000 (year 2), €40,000 (year 3); r = 10%. Discount factors are 0.909, 0.826 and 0.751. PVs: 36,364 + 41,322 + 30,052 = 107,738. NPV = +€7,738, so accept. Payback: €90,000 is recovered in two years and the remaining €10,000 needs 10,000/40,000 = 0.25 of year 3, giving 2.25 years. The methods can disagree; NPV is preferred because it is measured in euros of value added.
Traps that cost marks
- Discounting the initial outlay, which occurs at t = 0.
- Using accounting profit instead of cash flow in NPV.
- Claiming a higher IRR is always better without comparing project scale.
- Treating a share-capital increase as debt, or equity as a liability.
- Quoting a ratio without interpreting it.