Analysis and interpretation of financial information
This domain tests ratio calculation and, more importantly, interpretation. You must explain what a ratio indicates, compare it with a benchmark or prior period, and link it to business drivers. A calculation without comment rarely earns full marks.
Ratio groups
Profitability includes gross margin, operating margin, ROCE and asset turnover. ROCE = operating profit / capital employed, where capital employed is total assets less current liabilities or equity plus non-current liabilities. It decomposes into operating margin × asset turnover. Liquidity includes the current ratio, quick ratio and cash cycle days. Efficiency includes inventory days, receivable days and payable days. Gearing compares debt with equity or capital employed. Investor ratios include EPS, dividend cover and dividend yield.
Worked example
Operating profit is 120, revenue 1,200 and capital employed 800. Operating margin = 120/1,200 = 10%. Asset turnover = 1,200/800 = 1.5 times. ROCE = 120/800 = 15%, which equals 10% × 1.5. If last year's ROCE was 18%, the fall could come from a lower margin, lower asset turnover or higher capital employed. A margin fall may reflect discounting or cost inflation; a turnover fall may reflect idle assets or slower sales. State the likely driver and the evidence.
Interpretation discipline
Use averages for balances where the ratio compares a flow with a stock. Keep numerator and denominator consistent: do not divide profit before tax by equity when the ratio intends return to shareholders. Consider accounting policies, seasonality, one-off items, lease treatment and acquisition effects. Ratios are indicators, not proof of cause; support conclusions with cash flow and notes.
Traps
Do not compare ratios without checking definitions. Do not ignore tax, interest or non-controlling interests when calculating investor ratios. Do not treat EBITDA as cash flow. Do not overstate conclusions from a single year.