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A guide to ratio analysis in accountancy exams

Evaluating financial statements using ratio analysis tends to cause many students real problems in high-level, professional papers, such as CIMA E3 and ACCA P3.

Providing an answer that is too simplistic or uninformative will upset the markers in any paper. As an accountant, understanding financial statements is a fundamental skill that you must be able to demonstrate – whether you work in an accounting practice or as an accountant in industry.

In an exam scenario, there are seven key tips that will help you score well in this area:

1. Read the question carefully

The question may give you some ideas about which areas the examiner is particularly interested in you discussing. Are you being asked just to analyse the profitability of the organisation? Or take a wider approach and examine the organisation’s financial statements as a whole?

2. Consider the three key financial analysis areas and learn the appropriate ratios

If the question asks for a general analysis of the financial statements, be aware of the three key areas of financial performance for most businesses:

  • Profitability
  • Liquidity & working capital management
  • Investor ratios

Make sure you consider each of these areas in your answer and learn the formulae for the appropriate ratios. For example, profitability may be examined by looking at gross and net margins, as well as return on investment (ROI). Working capital management and liquidity may involve the calculation of receivables, payables or inventory days. Investor ratios may include gearing, interest cover or earnings per share. Knowledge of these ratios is fundamental to success.

Note that the examiner may highlight other areas of importance. For example, if you are given information on employee numbers, you may be expected to calculate sales per employee as a key ratio.

3. Be sensible with your selection of ratios

You will not have time to calculate every possible ratio. Instead, you need to try to focus on what is important. For example, if a business has low levels of inventory, calculating inventory days won’t tell you much – it will just waste time.

4. Provide comparatives

Most ratios are simply not useful in isolation. For example, if you calculated that a company’s receivables days are 45, you have no way of deciding if this is reasonable without something to benchmark it against. Commonly this will be either the company’s figures from last year, or industry averages.

5. Don’t be afraid to mention easy numbers

Not everything that you need to say will be based on a formal ratio. For example, have sales grown? Is there a large overdraft? These observations can all form the basis of useful points.

6. Put your calculations in context

This is arguably the most important issue when performing financial analysis. In a high-level exam, there will be relatively few marks for performing the calculations. The bulk of the credit will be for analysing the results.

Beware of simply stating that the ratio has gone up or down! This is not sufficient and will not earn you credit in higher-level papers.

Once you’ve worked out your ratios and key figures, to score well you need to consider two questions:

  • Why? What has caused the figure or ratio that you have calculated to change? You will normally find this from either your other calculations or from the question scenario.
  • So what? What implications does your calculation have for the company? Is it good or bad? Why would the directors care if you told them about your figures For instance, let’s say you’ve calculated the gross profit margin for a company in an exam question:

Gross profit margin: 2011 = 11%, 2010 = 15%

Consider these two possible answers:

1. "The gross profit margin has fallen to 11%, as costs have risen faster than sales."

2. "The gross profit margin has dropped from 15% to 11%.This has been caused by new entrants creating price competition within the market. The company will need to find ways of either cutting costs or differentiating itself in order to compete with these new entrants." Answer 1 merely restates the figures and doesn’t add any further analysis, meaning it would not score well. The much stronger answer 2 explains why the change has occurred and how it may impact on the company.

7. Conclude

Your financial analysis should have given you an overall picture of the organisation. Try to round off your answer by identifying the key overall issues. Is it successful? Does it have cash worries? Do you need more information? Having a brief conclusion can earn you another couple of marks in the exam and really help better students stand out.

Being able to perform a good quality analysis of financial statements can be a key differentiator in the exam. Follow these tips to make sure you stand out.