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ACCA Applied Knowledge · Financial Accounting

Analysis of Financial Statements for ACCA Financial Accounting

Analysis of financial statements means using ratios and comparisons to judge a business's profitability, liquidity, efficiency, gearing and returns to investors. To solve questions, write down the formula, compute from the figures given, compare with a prior year or benchmark, then give a reason for the change. Always check the question's required formula.

What this chapter covers

This chapter teaches you to turn the numbers in a statement of profit or loss and a statement of financial position into judgements. You calculate ratios in five groups: profitability, liquidity, efficiency, gearing and investor ratios. Then you explain what the results suggest about performance and position.

It sits at the end of the Financial Accounting paper because it uses everything before it. You need to know how revenue, cost of sales, inventory, receivables, payables, non-current assets, equity and borrowings are built up. If you can prepare the statements, you can read them. Ratios also link to the consolidated statements and accounts preparation, since you may be asked to interpret the figures you have just produced.

In the computer-based exam, this chapter mostly appears in Section A as short objective questions: a number entry for a ratio, a multiple choice on what a change means, or a multiple response on likely causes. Because every question is compulsory and the exam is two hours, you need fast, accurate formula recall and a clear sense of what each ratio tells you.

Ratio questions are some of the most predictable in the paper. The calculations are short, the formulas are fixed, and the traps are well known, so careful practice turns them into reliable marks. The interpretation skills also help you in Management Accounting performance measurement and in later ACCA papers. Since the pass mark is 50% and every question is compulsory, secure marks here offset harder questions on consolidations or accounting standards.

Analysis of financial statements: topics in the order to study them

  1. 1Purpose and Users of Financial Statement AnalysisStart here to learn who uses ratios and why, so every later formula has a purpose and a limitation attached.
  2. 2Profitability RatiosMargins and return on capital come from the statement of profit or loss, which you know well, so they build confidence early.
  3. 3Liquidity and Working Capital RatiosThese use current assets and current liabilities and prepare you for the cycle measures that follow.
  4. 4Efficiency and Asset Turnover RatiosReceivable, payable and inventory days extend the working capital ideas and link directly to the liquidity results.
  5. 5Gearing and Investor RatiosThese bring in debt, equity and share data, which need the earlier ratios as context and have the most formula variations.
  6. 6Interpreting Ratios and Writing a ReportStudy this last, because it combines every ratio group into a clear judgement supported by evidence.

How to prepare Analysis of financial statements

Aim to know each formula without looking, then practise using it on realistic figures and explaining the result in one sentence.

  1. Write a one-page formula sheet grouped by profitability, liquidity, efficiency, gearing and investor ratios. Include what goes on the top and bottom of each fraction.
  2. For each ratio, learn one sentence on what a rise or fall usually suggests, and one reason that could mislead.
  3. Practise number entry questions with a calculator under time. Check the rounding and units asked for, such as days, times or percentages.
  4. Take one set of statements and calculate every ratio for two years. Then comment on the changes, linking ratios together, for example falling margin with rising sales.
  5. Do mixed multiple choice and multiple response sets. For multiple response, select exactly the number stated and test each option against the figures.
  6. Finish with timed Section A style practice and review each wrong answer by cause: wrong formula, wrong figure, arithmetic or misreading the question.

Common mistakes in Analysis of financial statements

  • Using the wrong denominator, such as revenue instead of cost of sales for inventory or payables days.

    Fix: Pair each balance with its flow: inventory and payables with cost of sales, receivables with revenue. Check your formula sheet before calculating.

  • Ignoring the formula or rounding the question specifies.

    Fix: Read the instruction line first. Use the stated definition and round only at the end.

  • Treating a high or low ratio as simply good or bad.

    Fix: Ask what could cause the change and what other ratio supports it. A high current ratio may mean idle cash or slow-moving inventory.

  • Comparing figures from different bases, such as year-end balances against average figures.

    Fix: Use the same basis for every year and every comparison, and state it if the question allows.

  • Selecting too many or too few options in multiple response questions.

    Fix: Note the required number, test each option against the figures, and select exactly that many.

  • Forgetting that ratios depend on accounting policies and one-off items.

    Fix: Remember that depreciation policy, revaluations, year-end timing and unusual items can distort comparison between years or companies.

Last-day revision: Analysis of financial statements

  • Gross profit margin = gross profit ÷ revenue × 100; operating profit margin uses profit from operations.
  • Return on capital employed = profit before interest and tax ÷ (total assets − current liabilities) × 100.
  • Current ratio = current assets ÷ current liabilities; quick ratio excludes inventory.
  • Inventory days = inventory ÷ cost of sales × 365; receivables days = trade receivables ÷ revenue × 365.
  • Payables days = trade payables ÷ cost of sales × 365 (use credit purchases only if given).
  • Asset turnover = revenue ÷ capital employed or net assets, as the question states.
  • Gearing = debt ÷ equity, or debt ÷ (debt + equity); use the version the question gives.
  • Interest cover = profit before interest and tax ÷ finance costs.
  • Earnings per share = profit attributable to ordinary shareholders ÷ weighted average ordinary shares.
  • Price/earnings ratio = market price per share ÷ earnings per share.
  • Dividend cover = profit for ordinary shareholders ÷ ordinary dividends.
  • Always compare with a prior year or benchmark, and give a reason, not just a direction.

Analysis of financial statements practice questions

Analysis of financial statements in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Analysis of financial statements: frequently asked questions

How are analysis of financial statements questions tested in the FA exam?

They mainly appear as objective test questions in Section A, which has 35 two-mark questions. You may calculate a ratio as a number entry, pick the correct meaning of a change, or select several likely causes. Ratios may also support interpretation in the longer questions.

Do I need to memorise all the ratio formulas?

Yes, because the exam is computer-based and you cannot look them up. Learn them by group and by what goes above and below the line. Practise until you can write the full set from memory.

Which ratios should I study first?

Start with profitability, because it uses the statement of profit or loss you already understand. Then move to liquidity, efficiency, gearing and investor ratios. Finish with interpretation, which pulls them together.

How do I improve at interpreting ratios?

Calculate two years of ratios for the same business and write one sentence explaining each change, linking ratios where possible. For example, link falling inventory days to better liquidity or to possible stock shortages. Repeating this builds the habit of giving reasons, not just labels.