F2Advanced Financial Reporting

STUDY NOTES

STUDY NOTES

STUDY NOTES

Multiple-choice questions concerning a firm’s financial performance and position aren’t merely a test of your ratio-calculation skills. You would be well advised to apply the same systematic approach to any given scenario featuring a change in ratio values By Jayne Howson

Jayne Howson is a freelance lecturer specialising in financialmanagement, reporting and tax, and a marker for F2

RESOURCE STUDY NOTES

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Selected financial ratios for company H

Ratio 31 December 20X5 31 December 20X4Return on capital employed 15% 11%Gearing (debt/equity) 30% 45%

H records the same operating profit in both years.Which of the following statements, relating to H’s

activities in the year ended 31 December 20X5 and taken independently, would explain the movements in both financial ratios?A. The revaluation of land upwards.B. The issue of ordinary shares on the last day of the accounting period.C. The repayment of half of the debentures for cash.D. The bonus issue of ordinary shares from share premium.

A four-step route to the answerMultiple-choice questions are brief, so it’s worth bearing in mind that it’s unlikely that they will include much, if any, irrelevant information. We need to do the following:1. Read the whole question carefully to determine which ratios are being tested.2. Think about the information provided in the scenario and consider why it may have been given.

The latter requirement demands more consideration in the exam, so let’s focus on that. I’ll start by looking at a sample question and then set out a systematic approach that will arrive at the correct answer.

Sample questionCompany H prepares financial statements to 31 December each year. On 31 December 20X4 it had one million $1 ordinary shares in issue and $750,000 of 8 per cent debentures. The following ratios have been calculated from its audited financial statements:

The F2 exam is an online assessment comprising questions requiring short answers. Some of these will be in multiple-choice style, requiring candidates to choose the right solution from four given options. The topic “Analysis of financial performance and position” takes up 25 per cent of the F2 syllabus. The format of the exam means that you won’t need to write a report discussing the analysis (as you might have been asked to do under the previous syllabus). Instead, it’s likely that you will be provided with a brief scenario and then be required either to calculate ratios or to decide what may have caused certain ratios given in the question to change in value from one period to the next.

3. Write down how each of the relevant ratios is calculated.4. Take each answer option in turn and think through how it would affect each ratio.

Let’s now apply this approach to the question.1. Which ratios are being tested? The scenario states that they are return on capital employed (ROCE) and gearing. A question will always state how a company’s gearing has been calculated, as alternative methods exist for this. 2. Why has the information been given? The opening paragraph sets the scene and we should take the following into account:– H is geared, because it is financed by both equity (ordinary shares) and debt (debentures).– The company’s debt and equity figures are given as at the end of the previous accounting period. Why would this be the case? Expect a change in the coming year.– Its operating profits are the same level for both years. Why would this be stated? Expect a movement in finance costs and/or tax as one of the answer options. 3. How are the ratios calculated? ROCE is expressed in percentage terms as operating profit ÷ capital employed. (Operating profit is profit before finance costs and tax; and capital employed is share capital issued plus reserves and non-current liabilities, excluding provisions and deferred tax liabilities.) Gearing is expressed in percentage terms as debt ÷ equity. (Debt is non-current liabilities, excluding provisions and deferred tax liabilities; and equity is share capital issued plus reserves.) 4. How does each of the answers given affect each ratio? When you’re working through the four options it’s important to consider which figures on the financial statements will be influenced by the transactions described. Note that the financial statements relate to activities in the year 20X5, so you’re looking for whether they make the ratios for that year higher or lower than those in the previous year. In this question, ROCE has increased while gearing has decreased.

A. The revaluation of land upwards. Land is not subject to depreciation, so H’s operating profit will not be reduced by an increase in expenses, but the revaluation reserve will increase. This is recorded in both capital employed and equity, affecting both ROCE and gearing. The numerators of both ratios don’t change, while the denominators for both increase, so both ratios fall in value. You can therefore conclude that A is not the correct answer.B. The issue of ordinary shares on the last day of the accounting period. This would suggest that H doesn’t have time to use the funds to increase its trading activity, so the operating profit would not be affected this year (although it may be in future years). The capital employed and the equity both increase because there is an increase in the amount of share capital issued. The numerators of both ROCE and gearing don’t change, while the denominators for both increase, so both ratios fall in value. You can therefore conclude that B is not the correct answer.C. The repayment of half of the 8 per cent debentures for cash. The repayment of debentures reduces the level of non-current liabilities, thereby reducing the denominator for ROCE and also the numerator for gearing. The ROCE increases, therefore, while gearing reduces. Interest payments are saved, but the operating profit is calculated before finance costs, so it remains unchanged. You can therefore conclude that C is the correct answer.D. The bonus issue of ordinary shares from the share premium. A bonus issue involves no cash and is simply a transfer from a reserve to issued share capital. This will not change the value of either equity or capital employed, so both ratios are unaffected. You can therefore conclude that D is not the correct answer.

Working through this question serves to highlight two important points for F2 students: know your ratio calculations and always think through the information provided in each question carefully and systematically.