CIMA F2 Analysing financial statements: practice questions with answers

Question 1

Jarrow Co's operating profit rose by 6% in 20X6, but its return on capital employed (ROCE) fell from 18% to 14%. Capital employed is measured as equity plus non-current liabilities at the year end. Which of the following events in 20X6 is most likely to explain the fall in ROCE?

1. A Repayment of a long-term loan out of surplus cash at the start of the year
2. B Continued use of ageing plant with no new capital investment
3. C An upward revaluation of the company's properties at 31 December 20X6
4. D A share buyback funded from surplus cash during the year

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Answer: C. ROCE = operating profit / capital employed. Profit rose by 6%, so the fall in ROCE must come from a much larger rise in capital employed.

A year-end upward revaluation credits a revaluation surplus to equity, increasing capital employed immediately. The extra depreciation on the revalued amounts will reduce operating profit in future years. Revaluations make ROCE hard to compare with earlier years, or with entities that use the cost model.

The other events all reduce capital employed, which would raise ROCE.

Question 2

Which of the following is an example of window dressing intended to improve Nutley Co's reported year-end liquidity?

1. A Revaluing land at the year end, in line with the company's usual policy of annual revaluations
2. B Drawing down a long-term loan on 30 December and holding the cash at the year end, then repaying the loan on 2 January
3. C Recognising a loss allowance against trade receivables that are unlikely to be collected
4. D Recognising a provision for a legal claim that the company will probably lose

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Answer: B. Window dressing means arranging transactions around the year end so that the financial statements look better than the underlying position, often reversing them shortly afterwards.

Borrowing long-term just before the year end and repaying straight after increases cash (a current asset) without increasing current liabilities, so the current ratio and cash position look stronger at the reporting date only. An analyst should look for unusual year-end balances and events reversed soon after the year end.

Question 3

Ockley Co's profit before tax rose by 25% in 20X6, but its cash generated from operations fell sharply and became negative. Which of the following is the most likely explanation?

1. A A large impairment of goodwill was charged in arriving at profit.
2. B Ockley Co raised significant new long-term borrowing to fund capital expenditure.
3. C Suppliers agreed to give Ockley Co longer credit, so trade payables increased.
4. D Rapid sales growth led to large increases in trade receivables and inventory.

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Answer: D. Cash generated from operations = profit before tax + non-cash expenses (such as depreciation and impairment) +/- working capital changes.

When sales grow quickly, a business needs more inventory and has more receivables outstanding. These increases are deducted in the operating cash flow, so profit can rise while cash falls. This is a classic sign of overtrading. Non-cash charges are added back, financing and investing flows are shown in other sections, and higher payables increase operating cash flow.

Question 4

Petworth Co's price/earnings (P/E) ratio is 28, while the average for its sector is 15. Which of the following is the most likely interpretation?

1. A The market expects Petworth Co's earnings to grow faster than those of the sector as a whole.
2. B Petworth Co's shares are cheap compared with the earnings they generate.
3. C Petworth Co must pay out a higher proportion of its earnings as dividends than other companies in the sector.
4. D Petworth Co's earnings per share must be higher than the sector average.

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Answer: A. P/E ratio = share price / earnings per share. It shows how much investors are willing to pay for each $1 of current earnings.

A P/E well above the sector average usually means that the market expects higher future earnings growth (or sees lower risk) than for other companies in the sector. Analysts should also check that current earnings are not temporarily depressed, which would also raise the P/E ratio.

Question 5

Shere Co buys all its raw materials from its parent company at prices 20% below market prices. An analyst is comparing Shere Co's results with those of independent competitors. What effect is this arrangement most likely to have on the comparison?

1. A There is no distortion, because IAS 24 requires related party transactions to be restated at market prices.
2. B Shere Co's gross profit margin is lower than it would be on arm's-length terms.
3. C Only Shere Co's liquidity ratios are affected; its profitability ratios are not.
4. D Shere Co's gross profit margin is higher than it would be on arm's-length terms, so comparisons with independent competitors overstate its performance.

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Answer: D. Transactions with related parties may not be on arm's-length terms. Here, Shere Co's cost of sales is lower than an independent company would pay, so its gross and operating margins are overstated compared with competitors.

IAS 24 Related Party Disclosures requires the relationship and transactions to be disclosed, which alerts users, but it does not require the figures to be adjusted. The analyst should adjust for the arrangement or interpret Shere Co's margins with care, especially if the parent might stop the arrangement.