Analysis and Interpretation of Financial Statements, Ratio Analysis and Cash Flow Statements
What the domain tests
This domain tests ratio calculation and interpretation across profitability, liquidity, efficiency, gearing and investment, plus the statement of cash flows. You must explain what a ratio means, not just compute it.
Core rules
- Profitability: gross margin = gross profit/sales; net margin = profit before tax/sales; ROCE = operating profit/(equity + non-current liabilities).
- Liquidity: current ratio = current assets/current liabilities; quick ratio = (current assets - inventory)/current liabilities.
- Efficiency: inventory days = inventory/cost of sales x 365; receivables days = receivables/credit sales x 365; payables days = payables/credit purchases x 365.
- Gearing = debt/(debt + equity) or debt/equity. Interest cover = operating profit/finance cost.
- Cash flow statement: operating, investing and financing activities. Indirect method starts with profit before tax and adjusts for non-cash items and working capital.
Worked example
Current assets 150,000; inventory 60,000; current liabilities 90,000. Current ratio = 150,000/90,000 = 1.67. Quick ratio = (150,000 - 60,000)/90,000 = 1.00. Reason: inventory is excluded from the quick ratio because it may be slow to convert to cash. A quick ratio of 1.0 suggests current liabilities are covered by liquid assets, but the quality of receivables still matters.
Traps
Do not compare ratios across different accounting policies without adjustment. Do not treat a cash receipt from a share issue as operating cash. Do not ignore seasonality or window dressing. A high current ratio may reflect slow inventory, not strength.