Financial Analysis

Question Paper, Answers and

Examiners Comments

Level 5 Diploma June 2014

 Copyright of the Institute of Credit Management

Institute of Credit Management

The Water Mill, Station Road, South Luffenham, Oakham, Leicestershire LE15 8NB
Bookshop Tel: 01780 722901. Education Tel: 01780 722909
Switchboard Tel: 01780 722900. Fax: 01780 721333

June 2014 Continued

9FIA/PQP/2
 Financial Analysis questions, answers and examiners
comments

LEVEL 5 DIPLOMA IN CREDIT MANAGEMENT

JUNE 2014

Instructions to candidates

All questions carry equal marks.

COMPULSORY SECTION
Answer ALL questions Time allowed: 3 hours

It was disappointing that so few candidates passed the Financial Analysis paper this year;
however it does confirm that poor preparation, leading to inaccurate, generalised answers,
will be insufficient to gain a pass in this paper.

At Level 5, candidates are expected, where appropriate, to make reference to and/or give
examples from the Directors Report and Financial Statements to gain additional marks.

In general, answers lacked depth, which may reflect a lack of engagement with the
recommended textbook. Candidates should be warned that the study guide is simply that, a
guide. It is not a substitute for the textbook, which contains much more detail on the topic
and useful practical exercises to help prepare candidates for the examination.

June 2014 Continued

9FIA/PQP/3
Background

Spring Garden Centres Ltd (SGC) is a well-established garden nursery company

which has both retail outlets (garden centres) and a wholesale nursery business that
sells mature plants to companies undertaking large-scale landscaping projects.

The company was started many years ago by a brother and sister who have since
died and left the business to several family members. It is a well-respected
company in the industry, known for the quality of its plant stock and the old
fashioned values of its company members.

However, in a difficult economic environment they face increased competition from

overseas companies, who can produce young plants at a much lower cost due to
lower labour overheads.

Even so, they have a niche market selling large, mature plants to landscaping
companies, who need a reliable supply of quality shrubs and trees, with a
guaranteed lifespan of many years. Most notably they sold many plants to
contractors before and during the 2012 Olympic Games.

Due to their family expertise in horticulture, they have neglected the administrative
side of the business and are currently trying to catch up with the rest of the
industry in computerising their stock and accounting systems.

For the past year they have invested a considerable sum of money in trying to
develop bespoke hardware and software for their business, but this has been slow
and beset with many design problems as the company they contracted for the work
failed to recognise the complexity of their business. In particular the unusual way
they value maturing stock, such as trees.

They have decided to terminate the contract with the previous computer software
design company and have approached your company with a view to you taking over
the project.

Your role

You are a credit manager for Technology Solutions Ltd, a medium sized software
design company, formed only two years ago by two young, talented software
designers.

The designers have met the owners of SGC and are very enthusiastic about the
plans. They love the idea of working with creative people, and as it is such a well-
known, established company, believe there will be few problems with the receipt of
progress payments during the contract.

June 2014 Continued

9FIA/PQP/4
You are naturally cautious and wish to investigate the credit worthiness of the SGC
before the resources of this new technology company are committed to this
substantial project.

Technology Solutions Ltd already has the cashflow problems typical of newly
established companies and you have been employed, at the suggestion of the bank,
to ensure they do not get any worse.

You have obtained a copy of SGCs most recent published financial statements and
having spent time reading and analysing them are now ready to advise Technology
Solutions Ltds entrepreneurial owners.

You are required to answer the following questions:

June 2014 Continued

9FIA/PQP/5
1. Explain the meaning of the opinion expressed by the auditor of Spring Garden
Centres Ltd in the audit report dated 31st August 2013, including:

a) The purpose of an audit. (3 marks)

b) Differentiate between a qualified and unqualified audit report. (4 marks)

c) Whether the audit report of SGC Ltd is qualified or not and the evidence you
use to justify this decision. (7 marks)

d) Discuss the difference between a limitation in scope qualification and a

fundamental uncertainty. (6 marks)

Total 20 marks
Question aims
To test the candidates knowledge in relation to:
Explaining the need for regulation
Outlining the role that auditors have in quality assuring the financial statements of
companies.

Suggested answer
This answer should include points made in the guidebook and textbook. It is an opportunity
for the candidate to demonstrate what they have learnt about audit, and so any reasonable
comment will be given marks.

Key points
a) An audit is an Independent examination of evidence from which the financial
statements are derived, in order to give an opinion as to whether they show a true
and fair view of the state of the affairs of the company.

b) An unqualified audit report means that the auditors agree that the financial statements
show a true and fair view.
A qualified report means that the auditors, for various reasons, cant agree that the
financial statements show a true and fair view and so they have to vary/qualify/modify
their opinion.

c) The audit report of Spring Garden Centres Ltd is an unqualified (or unmodified) audit
report, but it contains an Emphasis of Matter paragraph. This is not a qualification.

An emphasis of matter paragraph does not mean that the financial statements do not
show a true and fair view because they do.
An emphasis of matter is used by the auditor to draw the attention of the reader to a
specific issue about which they should be aware.

June 2014 Continued

9FIA/PQP/6
 It means that the auditors are highlighting a fundamental uncertainty that is crucial to
an understanding of the financial statements. This is useful to the credit manager as it
identifies the potential risk of trading with such companies.

d) A limitation in scope means that there is some uncertainty as the auditor has been
unable to obtain sufficient evidence to form an opinion on either one balance in the
financial statements or on the financial statements as a whole. This will cause them to
issue either a qualified report or a disclaimer (cant form an opinion).

Whereas an emphasis of matter relates to an uncertainty over an event that the

company has no control over but which may affect the companys financial statements in
the future. It has been properly accounted for in the statements, so they show a true
and fair view, but it is so important to understanding the financial statements the
auditor draws the users attention to it.

N.B. Credit is awarded where candidates use appropriate evidence from the accounts.
Total 20 marks

Candidates scored well on the first part of this question, demonstrating sound general
knowledge on the objective of audits. However marks were lost by their inability to apply
this knowledge to the scenario. Vague statements, such as uncertainty is huge are
unacceptable. Candidates must give accurate interpretations of the meaning and implication
of the opinion given by the auditor. An example might be uncertainty is such that the
auditor does not have sufficient evidence to express an opinion.

For part d) weaker candidates only considered either limitation in scope or fundamental
uncertainty and did not discuss the difference which was required.

June 2014 Continued

9FIA/PQP/7
2. The financial statements published by SGC Ltd have been prepared in
accordance with UK generally accepted accounting practice and Companies Act
2006. The Conceptual Framework that underpins such accounts identifies four
essential qualitative characteristics of financial information: relevance, reliability,
understandability, and comparability.

Task
a) Discuss each characteristic in the context of the credit decision. Use examples
from the financial statements of SGC to illustrate your discussion. (12 marks)

b) Explain the limitations of relying solely on the financial statements to inform

the credit decision. Use appropriate examples of the information from the
narrative part of the annual report of SGC Ltd, which would be useful to the
credit professional in making a credit decision. (8 marks)
Total 20 marks
Question aims
To test the candidates knowledge in relation to:
Examining the authority that the International Accounting Standards Board (ISB) has in
UK financial reporting
Discussing the impact of current issues in financial reporting on credit managers.

Suggested answer

a)
Characteristic Context of credit decision Example from SGC Ltd

Relevance Information should have the Any relevant example will be

ability to influence the decision
made by the credit professional
Reliability Information that is complete and
faithful, so the credit professional
can rely on it
Understandability The significance of the information
can be perceived by the credit
manager
Comparability Similarities and differences can by
discerned and evaluated by the
credit professional, either from
year to year, or company to
company
June 2014
given credit e.g. Its important to
the credit decision that
information about a companys
short term liabilities is included for
an assessment of liquidity
E.g. In the example above if the
short term liabilities figure were
not complete it may mislead the
credit professional into granting
credit to a company with a poor
liquidity position.
E.g. assets are aggregated into
current and fixed/non current.
E.g. the inclusion of the previous
years figures.
Continued

9FIA/PQP/8
b) Limitation of using Financial Statement

Comments could include:

Do not seek to meet all the information needs of all users, therefore they may not
give a complete picture of a companys financial position and performance

Contain a substantial amount of classification and aggregation, therefore the

information needed by the credit professional may not be explicit

Focus on financial information, not non financial information which could be just as
important, e.g. technical issues

Information is historical rather than forward looking, so by the time the information is
published it could be out of date

Subject to different accounting policies, in particular on valuation of assets.

Errors sometimes occur and so it is important that information is checked to other

areas in the report

Example from SGC Ltd

The information about the contract associated with the Olympics gives the user a context
within which to judge whether the companys previous and current year performance is
sustainable in the longer term.

Inconsistencies in the information provided in the Directors Report and Income Statement,
which should have been identified as part of the audit review

N.B. Although any reasonable example will be given credit, to identify factors that could
inform the credit decision is insufficient without explanation of their significance

Again vague, general comments will not attract marks, and some candidates gave limited
responses. Candidates must demonstrate an understanding of the necessary qualitative
characteristics of financial information required by the Conceptual Framework. The best way
to demonstrate this understanding is to give appropriate examples from the scenario, which
illustrate the concept. However candidates should note that when giving examples they
should ensure they explain why they illustrate the characteristic to get maximum marks.
Total 20 marks

June 2014 Continued

9FIA/PQP/9
3. One of the important assumptions that underlie the preparation of financial
statements is that the business entity is a going concern.
Task
a) Explain the meaning of the term going concern, with reference to its
relevance to a credit professional. (4 marks)

b) Discuss the quantitative and qualitative factors a credit manager would look
for in order to assess a companys going concern. (6 marks)

c) Construct a going concern assessment of Spring Garden Centres Ltd using the
information available. (10 marks)

Total 20 marks

Question aims
To test the candidates knowledge in relation to:
Identifying the concepts underlying financial statements
Summarise UK legal requirements covering financial reporting

Suggested answer

a) Going concern is defined as the assumption that an entity will continue in business for
the foreseeable future.

The foreseeable future is considered to be a minimum of 12 months from the date of

approval of the financial statements (12 months from the balance sheet date will also
be accepted as this is mentioned in International Standards).

This is important to the credit professional looking for assurance that the customer will
have the short term liquidity and solvency to repay any trade credit given.

A comment on the diminution of asset value and its effect on debt recovery could also
be made.

b) There is one mark available for each relevant indicator taken from the list in the study
guide.

Examples
Net current liabilities

Negative operating cash flows

Fixed term borrowings approaching maturity without realistic prospects of renewal

or repayment

Arrears or discontinuance of dividend

June 2014 Continued

9FIA/PQP/10
 Emergence of a highly successful competitor

Loss of key customer etc.

c) The following are examples of the points which could be made. Each relevant point
with a full explanation will be awarded 2 marks up to a maximum of 10 marks overall.

Examples:
SGC does not have net liabilities or net current liabilities, and their cash balance is
considerable being 12% of all assets. Therefore they dont appear to have liquidity
problems.

Interest cover of less than 1 means that the company doesnt generate sufficient profit
to cover the interest payments on their loans. This cannot continue indefinitely.

There are no loans falling due in the next year that the company doesnt have the
resources to pay back.

Cash flows are not negative but are substantially reduced and if trends continue will
become negative in the subsequent period.

Dividends are not proposed for the current year, and the suspension of a dividend is
often an early sign of company distress. However considering this is a family firm,
where most of the shareholders are likely to be family members, the action may be
considered prudent and a sign of good management.

There dont appear to be any operating indicators such as loss of key employees/
management. However the Olympic contract of the previous two years may have
obscured underlying difficulties in the business, which are starting to be revealed now
that it is at an end.

The emphasis of matter paragraph in the audit report highlights a possibility that
profits in the future may be impacted by a write down of stock values. This may
contravene loan covenants, which may trigger insolvency.

Overall there are no signs of current going concern issues, but there is evidence of a declining
performance and position, which if it continues may affect the companys ability to continue in
the future.
This question addressed the important concept of going concern. Candidates should
familiarise themselves with key indicators of going concern in the financial statements of
companies as they are highly relevant for assessing the future solvency of customers seeking
credit terms. As in other questions poorly prepared candidates might describe a figure or
movement in a figure as good. This is insufficient and not evaluative, so a comment such as
an increase in cash is good is unlikely to attract marks. However a comment such as an
increase in cash has improved the companys liquidity and therefore the likelihood of making
payments in the immediate future, would gain marks.
Total 20 marks

June 2014 Continued

9FIA/PQP/11
4. SGC Ltd has included a Cash Flow Statement for the year ended 31st August
2013 in its annual report. Keeping in mind that your company is a potential
supplier:

Task

a) Carry out a full analysis of SGC Ltds Cash Flow Statement, evaluating its
potential future net cash inflows/outflows. (15 marks)

b) Contrast the usefulness of the cashflow statement to the credit professional

as compared to the Income Statement. (5 marks)

Total 20 marks

Question aims
To test the candidates knowledge in relation to:
Identifying the main causes of a change in cashflow
Using cashflow information to evaluate the financial position of an entity
Explaining the relevance of cashflow statements to the credit manager

Suggested answer

a) Analytical comment

The decline in operating cash flows (1,401,000) is caused partly by a fall in operating
profits of 550,000. The company explains that this fall in profits is due to adverse
weather conditions affecting the market as a whole.

Also trade creditors have decreased by 311,000, whereas they increased last year by
195,000. This has an overall effect of decreasing cashflow by 506,000. A decrease in
trade creditors may mean that the company is paying more promptly, or it could mean
that suppliers are reducing credit limits and demanding cash.

In the previous year cashflow was increased by decreasing stock levels, this has slowed
this year. Combined with the auditors comment on stock valuation this may reflect the
uncertainty around the valuation of stock.

In the previous year the company spent a considerable amount on buying new fixed
assets (2,806,000), which they financed with new loans (2,000,000). In the current year
investment in new fixed assets has reduced to 800,000 and has been financed through
the sale of fixed assets (918,000). Starting to sell fixed assets may be a first sign of
cashflow management problems or it may be a reflection of a reduced need due to
expenditure in the precious year.

June 2014 Continued

9FIA/PQP/12
 Overall the company has created sufficient cash to pay its loan interest and repayment
obligations and have a small surplus. However this is a declining trend and may reflect a
decline in business post the Olympic contract.

b) Comments could include:

Financial statements are prepared under the accruals basis; therefore profit is no
indicator of liquidity, i.e. cash in the bank. A cashflow statement is more reliable in
explaining where a company has generated cash.

Also profit is calculated using different accounting policies and underlying assumptions,
so is a relatively subjective figure, whereas the cashflow is objective, the company either
has it or it doesnt.

Profit is needed for the long-term growth of a company, as a company that makes losses
may continue for a short time but ultimately will fail as it wont make business sense to
continue. Cash is a better indicator of short-term sustainability as no matter how
profitable a company is, if it doesnt have access to cash it cant pay wages, suppliers etc
and will fail fairly quickly.

Any other relevant and reasonable comment will be given credit

An analysis of the statement of cashflows will always be included in this paper because it is
a learning outcome of the module. Therefore there is no excuse for a poor answer,
particularly as the financial statements are published in advance and candidates have ample
opportunity to study the statement of cashflows at length in preparation for the
examination, so timing should not be an issue.

Poor marks reflect poor preparation resulting in a lack of understanding.

Total 20 marks

June 2014 Continued

9FIA/PQP/13
5. You have obtained the following ratios:

RATIO Previous year 2012 Industry Average 2013

Return on Capital Employed 4.2% 5%

Net Profit Margin 2.6% 4%

Asset turnover X 1.56 X 1.8

Current ratio 1.65:1 2:1

Quick ratio 0.89:1 0.9:1

Stock turnover period 96.5 days 41 days

Debtor days 17 days 20 days

Creditor days 51 days 30 days

Gearing 41% 20%

Interest cover X2 X3

Task
a) Calculate these ratios for the current year (2013) from SGC Ltds Annual
Report, showing your workings. (5 marks)

b) Using both the industry average ratios and the previous years ratios as
comparisons, together with the information available in the annual report,
evaluate the financial position and performance of SGC Ltd focusing on the
matters which impact on the credit decision. (15 marks)

Total 20 marks

Question aims
To test the candidates knowledge in relation to:

Calculating relevant accounting ratios

Exploring the relationship between the ratios
Explaining the usefulness and importance of ratio analyses and their limitations
Extracting meaningful and useful information about a companys performance and
position from the annual report which would be relevant for a credit manager.

June 2014 continued

9FIA/PQP/June14/14
Suggested answer

a)

Current year 2013

Return on capital employed 1% (Accept 0.42%)

Net profit margin 0.2.75%

Asset turnover X 1.55

Current ratio 1.81:1

Quick ratio 0.99:1

Stock turnover period 95 days

Debtor Days 18.8 days

Creditor days 50 days

Gearing 47%

Interest cover X 0.5

b) There are many relevant and reasonable comments that a candidate might make, and
marks will be awarded on an individual basis.

A descriptive comment, such as debtor days have increased will not be given any
marks at this level, as candidates must give an explanation which identifies the
potential implications for the business, and any lender.

Therefore only analytical marks such as ROCE has fallen to only 1% which does not
compare favourably with either the previous period or the industry average. This can
be explained by a fall in profit margins as the companys asset turnover is relatively
stable will gain a mark.

Comments that synthesise information from elsewhere in the annual report will gain
marks. For example the comment on ROCE could be explained further by using the
comment in the directors report that the fall in profits is due to the poor economic
climate and adverse weather conditions is invalidated by the industry average.

Or a comment linking the effects of a possible write down in stock on profit as

highlighted in the audit report, with the declining performance.

June 2014 continued

9FIA/PQP/June14/15
Possible comments could include:

Fall in profitability

Explained and linked to

o Inconsistent with industry average
o End of Olympic contract
o Effect of a write down of stock highlighted in audit report
o Adverse weather conditions and poor economic climate highlighted in directors
report
o Amount spent on new computer system as highlighted in directors report

Fall in interest cover to 0.5 times

Company is not generating sufficient profit to pay the interest on its loans. This is
not sustainable in the long term and is well below the industry average

However in the short term they are generating enough cash to cover their interest
obligations

Increase in pension liability

This has long-term significance as it reflects the companys long term liability to pay
pensions over and above the assets it has set aside to fulfil this liability.

Uncertainty over stock valuation

If the unusual stock valuation results in a future write down in stock of the magnitude
highlighted in the audit report then this would have a detriment affect on profits in the
future and would lead to a much lower current ratio. Credit professionals should look to
the quick ratio rather than the current ratio for analytical purposes

Gearing

The companys bank loans of 5 million are secured on the companys freehold
premises, which are not valued at market values. They may have covenants, which
are triggered by falling profits or key performance indicators. Before giving a
substantial credit limit, credit professionals would be wise to get any details of this
considering the companys declining performance.

The company is not highly geared (47%), but it is increasing due to falling equity and
is approaching the point (50%) at which further loans are likely to attract a higher
rate of interest and may be more difficult to obtain.

June 2014 continued

9FIA/PQP/June14/16
Poor management

The fact that the company has spent considerable sums on a new computer system,
which is not yet up and running, may indicate poor financial management at the top
of this company. The fact that the company has many financial indicators below the
industry average would support this theory.

Again, ratio analysis will always be included in this paper and candidates are expected to
extend and develop their learning from their Level 3 studies for Accounting. However,
marks were lost in this question because candidates failed to carry out an analysis of the
scenario in the case study. Instead they carried out a generic ratio analysis and made
general comments about ratios which were more relevant for a manufacturing company.

Candidates must use appropriate ratios to interpret the scenario, not make vague comments
about ratios in general. Remember ratios are tools, just because you have learnt to use a
spanner you wouldnt try to change a plug with one! Candidates have plenty of time to study
the scenario in detail and link financial figures with information in other parts of the case
study, such as the notes and Directors report, to evaluate the performance and financial
position of a company. It can be considered a diagnostic approach, looking at all the
information available to come to a conclusion.
Total 20 marks

---oOo---

June 2014

9FIA/PQP/June14/17