AAT L4 Financial Statements Interpretation 2 — Questions and Answers

Question 1: Company X has a current ratio of 1.8 and an acid test (quick) ratio of 0.7. What does this suggest about the company's liquidity?

The company has strong liquidity with no concerns
The company's liquidity depends heavily on converting inventory to cash, which may be a risk (Correct answer)
The acid test ratio shows the company is highly liquid in the short term
A current ratio of 1.8 is too high and indicates inefficient working capital management

Correct answer: The company's liquidity depends heavily on converting inventory to cash, which may be a risk

The large gap between current ratio (1.8) and acid test (0.7) indicates that most current assets are inventory. Since inventory is less liquid than cash or receivables, ability to meet short-term obligations depends on selling inventory quickly.

Liquidity ratios measure a company's ability to meet short-term obligations. Current ratio = Current assets ÷ Current liabilities. Acid test (quick) ratio = (Current assets − Inventories) ÷ Current liabilities. A current ratio of 1.8 suggests the company has £1.80 of current assets for every £1.00 of current liabilities — apparently healthy. However, the acid test of 0.7 means excluding inventory, there is only £0.70 of liquid assets per £1.00 of current liabilities. The company cannot cover its current liabilities from cash and receivables alone. This large gap (1.8 − 0.7 = 1.1) reveals that the company holds substantial inventory (approximately 1.1 × current liabilities worth). The risk depends on: how quickly inventory converts to cash (inventory days), whether inventory values are realistic, the industry (retailers hold high inventory normally; service businesses do not), and whether there are seasonal factors. Interpretation must always consider the industry context. For a supermarket (fast inventory turnover), this may be acceptable. For a manufacturer with slow-moving inventory (e.g., bespoke machinery), an acid test below 1.0 could indicate genuine liquidity risk.

Question 2: A company's ROCE (return on capital employed) has fallen from 18% to 12% year-on-year. Operating profit has remained constant at £600,000. What has caused the ROCE to fall?

Operating profit has fallen
Capital employed has increased significantly (Correct answer)
Revenue has declined
Tax charges have increased

Correct answer: Capital employed has increased significantly

If ROCE = Operating profit ÷ Capital employed, and operating profit is constant, a fall in ROCE must be caused by an increase in capital employed. Previous CE = £600,000/18% = £3.33m. New CE = £600,000/12% = £5m — an increase of £1.67m.

ROCE (Return on Capital Employed) = Operating profit ÷ Capital employed, where capital employed = non-current assets + net current assets (or total assets − current liabilities). Previous capital employed = £600,000 ÷ 0.18 = £3,333,333. Current capital employed = £600,000 ÷ 0.12 = £5,000,000. Increase in capital employed = £1,666,667 (a 50% increase). This increase in capital employed could be caused by: major capital investment (new assets acquired), significant increase in working capital (receivables or inventory), acquisition of another business, or reduced current liabilities (paying off short-term debt). Without a corresponding improvement in operating profit, ROCE falls. A falling ROCE is a concern for investors and management because it suggests the company is employing more capital for the same return. Management should consider: whether new assets are generating returns (the new investments may not yet be generating profit), whether working capital management has deteriorated, and how to improve asset efficiency. ROCE is often used by analysts to compare capital productivity across periods and between companies.

Question 3: When interpreting a company's gearing ratio, which of the following indicates HIGH financial risk?

Gearing of 20% and interest cover of 8 times
Gearing of 75% and interest cover of 1.5 times (Correct answer)
Gearing of 45% and interest cover of 4 times
Gearing of 30% and interest cover of 6 times

Correct answer: Gearing of 75% and interest cover of 1.5 times

High gearing (75% — most of the capital structure is debt) combined with low interest cover (1.5 times — profits barely cover interest) indicates high financial risk and vulnerability to economic downturns.

Gearing ratios measure the proportion of a company's capital structure that is funded by debt rather than equity. High gearing is concerning because: debt must be serviced (interest) and repaid regardless of business performance, whereas equity (dividends) can be reduced. A highly geared company has less financial flexibility and is more vulnerable in a downturn. Gearing ratio = Debt ÷ (Debt + Equity) × 100% (or Debt ÷ Equity × 100%). At 75%, three-quarters of the company's capital comes from debt — this is very high. Interest cover = Operating profit ÷ Interest payable. A ratio of 1.5 means profit is only 50% above the interest charge. If profits fell by just 33%, the company could not cover its interest — a very thin margin of safety. Lenders typically require interest cover of at least 2–3 times; 1.5 times would be concerning to most creditors. Combining high gearing with low interest cover creates the worst risk profile: the company has high debt (structural risk) and barely generates enough profit to service it (income risk). Options A, C, and D show lower gearing and/or higher interest cover, indicating much lower financial risk.

Question 4: A company has operating profit of £240,000, interest payable of £40,000, and tax of £56,000. What is the profit for the year (net profit after tax)?

£200,000
£144,000 (Correct answer)
£184,000
£240,000

Correct answer: £144,000

Profit before tax = £240,000 − £40,000 = £200,000. Profit after tax = £200,000 − £56,000 = £144,000.

The structure of the income statement follows a logical sequence: Revenue − Cost of Sales = Gross Profit − Operating Expenses = Operating Profit (EBIT) − Interest Payable = Profit Before Tax (PBT) − Tax = Profit for the Year (net profit after tax). Operating profit (EBIT): £240,000. Less interest payable: (£40,000). Profit before tax: £200,000. Less corporation tax: (£56,000). Profit for the year: £144,000. This can also be checked: effective tax rate = £56,000 ÷ £200,000 = 28%. The UK main rate of corporation tax is 25% from FY2023, suggesting the company may have some adjusting items (deferred tax movements) that increase the effective rate above 25%, or this may be for an earlier year when the rate was different. For ratio analysis purposes: Operating profit margin = Operating profit ÷ Revenue (uses EBIT). Net profit margin = Profit after tax ÷ Revenue (uses PAT). The difference between the two margins reflects the burden of interest and tax. A wide gap suggests high leverage (interest cost) or high tax charges.

Question 5: An analyst notices that a company's inventory days have increased from 35 days to 62 days over the year. Which of the following is the MOST likely concern this raises?

The company is collecting cash from customers more quickly
The company may have slow-moving or obsolete inventory, or has over-purchased (Correct answer)
The company's credit terms have become more generous
The company has improved its gross margin by buying in bulk

Correct answer: The company may have slow-moving or obsolete inventory, or has over-purchased

A near-doubling of inventory days suggests inventory is accumulating faster than it is being used or sold. This may indicate slow-moving or obsolete stock, over-purchasing, or slowing demand — all of which are concerning for liquidity and asset quality.

Inventory days (or inventory holding period) = (Inventory ÷ Cost of Sales) × 365. An increase from 35 to 62 days means inventory takes nearly twice as long to turn over, which is a significant deterioration. Possible explanations and associated concerns: Over-purchasing (perhaps to secure bulk discounts — but ties up cash and increases obsolescence risk). Slowing sales (demand may be falling, leaving unsold inventory). Product obsolescence (older products no longer selling as fast). Supply chain disruption response (building buffer stock). Deliberate management policy (strategic stockholding). For a financial analyst, rising inventory days raises concerns about: liquidity (cash tied up in stock), asset quality (is the inventory stated at a realistic value, or should some be written down?), management efficiency (why hasn't purchasing been adjusted to match sales?), and potential for future write-downs (which would reduce profits and asset values). In contrast, if inventory days fell dramatically, this might indicate risk of stockouts and lost sales. The context and industry norm are essential — a food retailer should have very low inventory days; a yacht manufacturer might have high inventory days legitimately.

Question 6: Which financial statement ratio best indicates whether a company generates sufficient cash flow to service its debt obligations?

Current ratio
Debt to equity ratio
Interest cover ratio (Correct answer)
Return on equity

Correct answer: Interest cover ratio

The interest cover ratio (Operating profit ÷ Interest payable) directly measures how many times operating profit covers the interest charge, indicating ability to service debt from earnings.

Debt service capacity is assessed using ratios that compare income to debt obligations. The interest cover ratio = Operating profit (EBIT) ÷ Interest payable. A ratio of 3.0 means operating profit is three times the interest charge — the company can easily service its debt from earnings. A ratio below 1.5 is concerning; below 1.0 means the company cannot cover interest from operations. Current ratio measures short-term liquidity (whether current assets cover current liabilities) but does not specifically address interest servicing ability. Debt to equity measures the capital structure (how much debt is in the mix) but not whether earnings are sufficient to service it. Return on equity measures profitability for shareholders but not debt service capacity. For a more comprehensive view of debt service capacity, analysts may also use: DSCR (Debt Service Coverage Ratio) = Operating cash flow ÷ Total debt service (interest + principal repayments). This is particularly important for project finance and leveraged buyouts where principal repayments are a major obligation alongside interest. Lenders often impose minimum interest cover covenants in loan agreements (e.g., interest cover must remain above 2.5 times). Breach of such covenants can trigger early repayment demands, making interest cover monitoring critical for treasury managers.

AAT L4 Financial Statements Interpretation 2

Company X has a current ratio of 1.8 and an acid test (quick) ratio of 0.7.
What does this suggest about the company's liquidity?