How many of you plan to do Q.5 on the higher level paper next June?

If past Examiner’s Reports are anything to go by, probably about half of you. When you consider that Ratio Analysis (Interpretation of Accounts) is the nearest thing you can get to a certainty on the exam (it’s come up as Q.5 every year since the new syllabus was introduced in 1997) it’s odd that only one in two students do this question.

Bad rap

I know, Q.5 gets a bad rap. I’ve talked to a lot of students and teachers about this. Many students (and some teachers!) avoid ratios because they think it’s a hard question, or at least they think it’s hard to score high marks in! Well, that’s certainly true if you don’t know your ratios or how to calculate them. But the evidence suggests that most students actually do fine in part (a) where they have to calculate the five ratios. The truth is, that where students really fall down is in part (b) of the question, the interpretation bit.

Feedback from teachers who have corrected the exam, and insights from Chief Examiners Reports, highlight that many students don’t really understand what part (b) is all about. Often, the answers submitted to part (b) suggest that students have tried to rote-learn past solutions. Therein lies the problem. In part (b), you have to interpret the ratios and financial information in front of you. Students who can do this, and who present their arguments clearly, will excel in part (b) and therefore score very high marks in Q.5. As it’s a 100-mark question (25% of your total marks), a good score in this question will go a long way to securing the grade you need in accounting.

The 3 skills

Now for the good news. You don’t have to be a brain box or a H1 maths student to score well in Q.5. You just need 3 essential skills:

  1. Know the key ratios and be able to correctly calculate them.
  2. Understand what each of the key ratios actually mean.
  3. Have a roadmap to follow for interpreting ratios for the main stakeholders: i.e. Ordinary Shareholders, Lenders and Debenture Holders.

So, how do you perfect these skills?

Knowing the key ratios

This sounds easy but it’s not just about learning off a bunch of formulae. Yes, you do have to that. But you also have to be able to:

  • Identify the input figures for each ratio from the information given in the question;
  • Correctly calculate each ratio; and
  • Express your answer in the right format (percentage, cents, times, etc.).

This is a skill you can only develop with practice. To be honest, there’s no excuse not to score 100% in part (a) of the question. If you practice this 6 or 7 times, under simulated exam conditions (i.e. within the time allowed and with no distractions or interruptions), you should be well able to answer part (a). The first ratio can be tricky because you have to do some basic algebra to work out the answer but, once you’ve learned how to do this, it’s not difficult. With up to half of the total marks awarded for part (a), you can get yourself off to a great start in Q.5 right here.

Understanding what the key ratios mean

This really helps! Once you understand what the ratios are actually telling you, it’s an awful lot easier to figure out what’s going on. Each ratio has its own meaning. Once you understand it, you won’t have to try and guess whether the trend over the two years (up or down) is a good or a bad thing. You’ll just know. With some ratios, there are also basic rules of thumb that can be used to assess if the company is doing well or not.

Such rules of thumb must always be considered in your answer. For example, imagine the interest rate on the debentures is 8% and the Return of Capital Employed has increased from 5.8% to 7.5%. On the face of it, this an encouraging trend. But, as a rule of thumb, we’d like to see the ROCE being at 10% or higher. At a minimum, it needs to comfortably exceed the return from risk free investment but it should also exceed the rate of interest earned by the debenture holders, who are secured. So, in this example, although the trend is going in the right direction, the ROCE is still too low for ordinary shareholders to be satisfied. They’d be better off holding debentures instead of their shares.

Having an Interpretation Roadmap

This is vital. A roadmap gives you a structure to answer part (b) clearly and concisely, hitting all the right points you need to collect top marks. It also stops you waffling and wasting time writing stuff that won’t get you any marks! A roadmap is basically a set of headings which addresses all the key issues. There are slightly different headings depending on whether you’re being asked to advise an ordinary shareholder or lender/debenture holder.

For example, a bank lender won’t be overly concerned with the share price trend but he/she will be very keen to know what will happen to interest cover and gearing if the loan is made. They will also want to know that adequate security is available and that there is a clear and sensible purpose for the loan.

Each heading will focus on different ratios but the structure will be the same under each heading:

  • Call out the values for the relevant ratios and identify the trends in those ratios;
  • State clearly whether the trend is encouraging or worrying;
  • Compare ratios to any rules of thumb - state if comparison is encouraging or worrying;
  • State what the results mean for the stakeholder you are being asked to advise.

Back to our earlier example, your commentary under the heading of Profitability would look like this:

  • Return of Capital Employed (ROCE) has increased from 5.8% to 7.5%.
  • ROCE is well above the return from risk free investment (c.2%) and the trend is encouraging.
  • But ROCE is still well below the desired level of 10%;
  • Critically, ROCE is lower than the return being earned by the debenture holders of 8% who also enjoy greater security.
  • Although the company is profitable, ordinary shareholders would not be happy with this situation.
  • They would be better off holding the debentures rather than their shares.

Short, punchy and specific - this covers all the bases for Profitability and gets you full marks.

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