AAT L4 Financial Statements Interpretation 2

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?

Accepted Answer

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

Answer

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.

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?

Accepted Answer

Capital employed has increased significantly

Answer

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.

Question 3

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

Accepted Answer

Gearing of 75% and interest cover of 1.5 times

Answer

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.

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)?

Accepted Answer

£144,000

Answer

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

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?

Accepted Answer

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

Answer

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.

AAT Level 4 Practice Test

AAT Level 4 Practice Test

AAT L4 Financial Statements Interpretation 2