Financial Analysis

Question Paper, Answers and

Examiners Comments

Level 5 Diploma

www.icm.org.uk

June 2012

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 2012 continued

9FIA/PQP/1

Financial Analysis Questions, Answers and Examiner’s Comments LEVEL 5 DIPLOMA IN CREDIT MANAGEMENT

JUNE 2012 Instructions to candidates

Answer ALL questions Time allowed: 3 hours

Overall the majority of candidates achieved a pass mark, but 57% of candidates were

awarded a mark close to the pass/ fail boundary. These would appear to be good

candidates who made perceptive, intelligent, analytical comments, but overall were not as

familiar with the syllabus as the examiner would have hoped. Candidates tended to over-

stress one observation, e.g. the surrendered leaseholds, and repeat this several times

rather than take a more holistic approach. There were many observations which were highly

relevant to the credit decision that candidates ignored, e.g. the resignation of a director and

the sudden increase in prepayments.

Only one candidate achieved a distinction mark, which reflected their thorough knowledge

of the syllabus and a good ability to apply theory to professional practise.

Conversely the scripts of those candidates who failed clearly reflected a lack of preparation

for the assessment.

Future candidates should note that unfamiliar topics, such as cashflow statements cannot be

ignored and need to be studied more intently than their predecessors have. This topic has

been introduced due to its significant relevance to the credit professional.

June 2012 continued

9FIA/PQP/2

Off the Peg Ltd (OtP) is a retail fashion company which has been selling competitively-priced

adult clothing from 128 high street outlets. They are considering going upmarket with a

new branded range.

You are a credit manager for Red Earth plc a major retail property owning company that

owns 10 large ‘out-of-town’ shopping malls located throughout the UK.

The Chief Executive Officer (CEO) of OtP has approached your company with an offer to

lease a retail unit in each of your 10 malls. The lease agreement is for twenty five years

with a total rental of £800,000 per annum with upward rental reviews every five years to be

in line with the Retail Price Index. However the contract is conditional upon an outlay of

£300,000 by your company to refit all ten units to a minimum standard required by them.

They hope to further develop the stores in keeping with their upmarket brand.

It is understood that Off the Peg Ltd. is planning to obtain a loan of £1m, repayable in

fifteen years, at an interest rate of base rate + 8.5%. These funds are to be used fully to

further brand develop the ten properties in order to market their new upmarket range which

they believe will yield a gross profit margin of 75%. This loan is to be obtained in 2012

soon after the rental agreement for the ten properties is signed. Off the Peg Limited believe

that they will be entitled to the new government loan guarantee scheme and have informed

you that negotiations are at an advanced stage with a bank.

The Chief Financial Officer (CFO) of your company is understandably concerned that this

initial capital outlay by Red Earth plc carries a significant credit risk and has asked for your

opinion as to the long-term solvency and liquidity of OtP.

You have obtained a copy of the company’s most recent published financial statements and

having spent time reading and analysing them are now ready to answer your CFO’s queries

and concerns.

June 2012 continued

9FIA/PQP/3

You are required to write a memo addressed to your CFO that answers the following

questions:

1. a) Explain the meaning of the opinion expressed by the auditor of OtP Ltd in the audit

report dated 31 August 2011. (8 marks)

b) How relevant is it to the credit decision? (12 marks)

Total 20 marks

Suggested answers

It must be stressed that some aspects of the answers are absolute, i.e. right or wrong and

will attract marks appropriately. However some answers require reasoned opinion and in

this circumstance credit will be given for well- reasoned argument.

This question is in two parts; the first part requires knowledge of the meaning of an audit

report, but the second requires reasoned argument.

a) Essential comments for part one

The report is unqualified The auditor has expressed the opinion that

the financial statements show a true and fair

view

The report is addressed to the shareholders The report contains a disclaimer of liability to

any other body (this includes creditors)

The auditors state they comply with

prescribed ethical standards

This gives some assurance as to the

independence and hence objectivity of the

auditor

The report contains an emphasis of matter

paragraph

This is not a qualification. It merely

highlights an important uncertainty that the

directors have properly disclosed in the

financial statements

b) Students may argue either way for relevance or irrelevance but their reasoning must

support their argument.

An example of what could be written is as follows:

Arguments for the relevance of the audit report:

Provides assurance to users of the financial statements that the figures quoted are a

‘faithful representation’ or are ‘true and fair’.

June 2012 continued

9FIA/PQP/4

Reporting by exception means that the user can be confident that important material

facts will be brought to the attention of the reader.

This is exemplified in this case as the auditor has highlighted an important matter as

regards the company’s liquidity and hence solvency.

Arguments against the relevance of the audit report:

The report is untimely and credit decisions require up to date information.

The auditors have no liability to users other than shareholders and therefore this may

dissuade users from placing reliance on the information.

Only the statements themselves are fully audited, the narratives are only reviewed

for consistency, therefore the assurance the auditor provides is limited

Past cases have called into question the independence of auditors

Companies that fail rarely have a qualified report in the year before failure.

Total 20 marks

As stated by the examiner the purpose of this question was to test the candidates’

understanding of the relevance of the audit report to the credit decision.

Candidates lost marks because they didn’t answer the question. Having noted the ‘emphasis

of matter’ paragraph they then described the meaning of this in terms of the company’s

liquidity and solvency. Those candidates who gained good marks for this question also

considered the significance of a ‘true and fair view’ opinion and other aspects such as

auditor liability and the consistency of the financial statements and director’s report.

June 2012 continued

9FIA/PQP/5

2. a) Identify the regulatory framework that underpins OtP Ltd’s annual report.

(5 marks)

b) Explain the difference between the regulatory framework and the conceptual

framework. (5 marks)

Total 10 marks

Suggested answer

OtP Ltd has complied with:

Companies Act (2006)

UK Accounting Standards as published by the ASB (Accounting Standard Board).

There are various bodies that provide the regulatory framework for corporate reporting.

They include the government in the form of statute; professional accounting bodies in the

form of accounting standards; and where applicable, stock exchanges in the form of listing

rules. Together, this regulation is often referred to as UK GAAP. This stands for United

Kingdom Generally Accepted Accounting Principles, although some refer to ‘Practices’ rather

than ‘Principles’.

The conceptual framework is a foundation of principles upon which accounting standards are

built. This ensures a ‘consistency of approach’ between all standards and avoids conflicts

between different standards. In the UK the framework is called the ‘Statement of Principles’,

whilst the IASB produced a very similar framework for International Standards called the

‘Framework for the Preparation and Presentation of Financial Statements’.

In essence the conceptual framework forms part of the overall regulatory framework for the

preparation of published financial statements. Total 10 marks

Overall candidates performed poorly for this question, as the average mark was only 40%.

They appeared unsure as to the distinction between the two frameworks, in particular the

conceptual framework. This would seem to indicate that some students were not fully

prepared for the assessment.

June 2012 continued

9FIA/PQP/6

3. Using appropriate ratios, comment on the viability of obtaining the rent of £800,000 per

annum payable quarterly on the usual quarter dates. (20 marks)

Suggested answer

Given below are the calculations for the Current Ratio and the Acid Test

2011 2010

Current Ratio

1.04:1

0.97:1

Acid Test

0.71:1

0.54 :1

Current Ratio

The current ratio is obtained by dividing the current assets by the current liabilities. The

word ‘current’ means that these amounts are receivable or payable within the next year. It

will be remembered that Net current Assets (i.e. the difference between current assets and

the current liabilities) is often referred to as working capital. An organization can have

Working capital only if its current assets exceed its current liabilities. When current assets

exceed current liabilities the current ratios will be more than 1 and vice versa.

It is seen that in 2010 the company did not have working capital. There appears to be a

marginal increase in working capital in 2011 as compared with 2010.

Given below are the ratios relating to the efficiency of working capital management

2011 2010

Stock Days 39 days 48 days

Debtor Days 16 days 12 days

Creditor Days 121 days 111 days

There has been a marginal improvement in stock days which may mean that the company is

purchasing stock that is more readily saleable. It may also mean that there may be

situations where stock is unavailable when a customer needs to buy an item.

The most alarming figure in the above table is the creditor days. This seems to suggest

that many creditors are not getting paid on time as it is unlikely that a supplier would give

four months credit. This should ring some alarm bells to Red Earth plc particularly with the

expectation of a payment of £200k per quarter in terms of the proposed rent.

June 2012 continued

9FIA/PQP/7

The Acid Test

The Acid Test shows the funds that are readily available for payment to suppliers and other

short-term creditors. In this test stocks are omitted from the numerator as they are

considered to be the least liquid asset.

There has been a marginal improvement in this respect from 0.54:1 to 0.71:1. Despite this

marginal improvement this ratio is significantly below the level that is required to give

comfort to a potential short-term creditor such as Red Earth Ltd. The acid test should be at

least 1:1.

Implications for the Future

It is understood from the information given that OtP are planning to obtain a loan for £1m.

No part of this loan is designated to improve the working capital of the company. The

company currently appears to be heavily dependent on its suppliers and its short-term

creditors for working capital. An increased level of activity will inevitably put greater

pressure on the current unsatisfactory working capital situation.

In view of the above there is more than a significant probability that Red Earth will not

receive £200k rent on the usual quarter days. This lapse may give Red Earth the right to

repossess the shops but it may still have to spend significant sums in dismantling the brand

enhancing developments peculiar to OtP. Total 20 marks

This question was answered well by the majority of candidates, with the average mark

being 64%. Those who performed poorly made incorrect ratio calculations and tended to

repeat a single point. Learners should do well in this question as they have studied this

topic in previous ICM units, therefore those who performed poorly were clearly insufficiently

prepared for the assessment.

June 2012 continued

9FIA/PQP/8

4. Assuming that the balance sheet as at 31 August 2011 is unlikely to change significantly

up to the time of obtaining the loan, calculate the gearing of the company. In the

context of the information available in the financial statements and in the context of the

external factors within which Off the Peg Ltd. operates, evaluate, comment and advise

the CFO on the risks to the ‘going concern’ aspect of Off the Peg Limited.

(20 marks)

Suggested answer

Gearing

Gearing is the extent to which a company is financed by non-ordinary shareholders. At

present OtP is entirely financed by ordinary shareholders. Therefore there is an argument

for a degree of borrowing if those additional funds can yield a Return on Capital higher than

the interest that is payable. However, as the degree of borrowing rises, there is a rise in

risk and a corresponding rise in the interest rate to compensate for the increasing risk.

There comes a point of indifference when the interest cost additional borrowing is equal to

the Return on Capital and any further borrowing will not add to the net profit.

At present OtP is not geared. However, if a loan of £10m is obtained the company will be

geared by a dramatic 82%, i.e. loan/ net assets + loan. This shows that 82p of every £1 of

the capital of the company is borrowed. This is a very significant risk to the company.

Going Concern

The ‘Going Concern concept’ is the assumption that the company will be in existence, at the

same level of operation for the foreseeable future. This is an important assumption when

valuing some of the assets of the company.

For example it will be seen from Note 10 of the financial statements of OtP that £1.8m of

the Fixed Assets relate to fixtures fittings and equipment. It is likely that a large proportion

of this amount relates to the bespoke development of the shops. While it is correct and

acceptable to show this amount in the Balance Sheet as long as OtP exists and is

operational if one day it ceases its operations or reduces its activities significantly much the

fittings may end up on the skip and be of no value to anyone. Therefore many assets

decrease in value if the company is not a going concern.

In calculating the gearing it would be prudent to study the nature of the assets in the

balance sheet. In this Instance it can be seen that the net assets may not be worth the

amount shown in the balance sheet in the event that OtP ceases trading or significantly

reduces its operations. In view of this situation the actual gearing is likely to be higher that

the 82% calculated above.

June 2012 continued

9FIA/PQP/9

Context

It was seen that the context of ratio analysis can be described by the mnemonic COPIED

(Competition, Organisation type, PESTEL, Industry, Extracts, Data Age). Some of the

relevant factors of these are evaluated below.

Competition

The fashion industry is fiercely competitive. It is seen that the Directors Report says

‘The Company is operating in a challenging retail environment’. The proposed

development of an upmarket brand for a company that has been operating in a lower

market range would be difficult. Normally companies go downmarket and not upmarket

in fashion

PESTEL

Clearly the economy is likely to play a great part in the viability of the proposal. At

present the economy is not booming. No one expects a boom in the near future. The

political landscape appears to bring a great degree of uncertainty.

Data Age

OtP appears to prepare its financial statements rather quickly. Therefore the information

is more relevant for decision-making.

Conclusion

The auditors have stated that there is ‘material uncertainty’ in relation to the going concern

concept although they have not gone to the extent of qualifying their report of the financial

statements to 31 August 2011.

It is seen that the ‘material uncertainty’ would rise significantly with the proposed loan due

to the alarming rise in gearing.

It should also be noted that Red Earth will have to part with £300k in order to obtain the

contract. There is significant risk that there may not be a return for the funds expended

and that the rent of £800k per annum may not be received due to problems with working

capital or indeed in relation to the very survival of OtP. Total 20 marks

Candidates struggled with this question, average 49%, and many failed to grasp the impact

that the loan would have on the company’s capital structure as shown by the change in

gearing. However the majority of students were able to synthesis external factors with

financial information and gave reasoned opinions that informed the credit decision. This was

very encouraging. Some learners did repeat the same observation several times and future

candidates should note that marks cannot be awarded twice, so repetition is a poor use of

candidate’s time.

June 2012 continued

9FIA/PQP/10

5. The company has made significant operating losses over the last two years, yet

according to the cashflow statement has made positive operating cash inflows.

a) Explain using both facts and figures, how OfP has generated cash yet managed to

make an operating loss. (10 marks)

b) Using other information in the financial statements of OtP Ltd, give possible

explanations for the movements in working capital. Identify the relevance of this

to the credit decision. (10 marks)

Total 20 marks

Suggested answer

a)

Reconciliation of operating loss to

operating cash flows 2011 2010

£000 £000

Operating loss (932) (1,048)

Depreciation and impairment charges 1,485 1,995

Decrease/(increase) in stocks 924 (570)

(Increase)/decrease in debtors (371) 497

Increase/(decrease) in creditors 38 (657)

Net cash inflow from operating activities 1,144 217

In both years OtP Ltd has reported operating losses of approximately £1 million, although in

2011 this improved by £116,000.

When those losses are adjusted for subjective non- cash estimates, such as depreciation,

the company can report earnings of £553,000 (2010: £947,000).

This figure is sometimes called EBITDA (Earnings before Interest, Tax, Depreciation and

Amortisation) and is sometimes used by analysts as an approximation for operating

cashflow as it removes non-cash estimates.

However if we relied on these figures alone we would see a declining position, whereas the

net cashflow from operating activities shows an improving figure of £1,144,000 (2010:

217,000).

June 2012 continued

9FIA/PQP/11

This increased cashflow appears to be caused by a complete reversal of working capital

management from 2010 to 2011.

In 2010 OtP Ltd increased its stock (inventory) holding by £570,000 and paid significantly

more creditors (payables) (£657,000) than the previous period. Both of these practices

reduced operating cashflow, which would have shown a net cash outflow if the company

hadn’t successfully recovered more from its debtors in the year (£497,000).

Conversely in 2011, OtP Ltd reduced its stock (inventory) holding and made a slight

increase in creditors, which improved its operating cashflow. However in this year debtors

(receivables) increased, thereby reducing the increase in cashflow achieved by the

decreased stock holding.

b) Learners should identify the strong possibility that this company may be having issues

in obtaining credit from suppliers. Indicators are:

Increased payment of creditors in 2010

Even though there is an overall increase in creditors, there is a decrease in TRADE

creditors in 2011 (see notes)

Reduction in overall stock levels for a company that trades on up –to –the-minute

fashion

Increase in prepayments (in notes to debtors), i.e. cash in advance

Any other relevant point

This has significant interest for the credit decision, as companies with a longer relationship

with this company may be asking for cash in advance or on delivery.

Together with the emphasis of matter paragraph in the auditor’s report which identifies the

company’s reliance on short term finance, i.e. a bank overdraft, any credit professional

would consider this a high risk company to extend credit to. Total 20 marks

Cash flow statements are a new topic for candidates, so it is perhaps unsurprising that

answers to this question achieved the lowest average mark (27%). Candidates made

fundamental errors in their interpretation of the operating cashflow, which revealed a lack of

understanding. A good example is the fact that some students thought that depreciation

improves cashflow, it doesn’t, it reduces profit. Future candidates should note that this topic

is a key learning outcome and will always be included in the assessment, so care should be

taken to fully understand the topic.

June 2012

9FIA/PQP/12

6. Evaluate the significance of the Income Statement compared to the cashflow statement

when making credit decisions. (10 marks)

Suggested answer

The credit decision requires information regarding a customer’s short term ability to pay

suppliers, i.e. liquidity, but also its long term sustainability, i.e. profitability. The Income

statement can provide information about profitability but not liquidity. The cashflow

statement can provide liquidity information but has limited value in judging a company’s

long term profitability.

Therefore both statements are important to the credit decision.

One of the problems that exist with determining profit is that many of the figures included

in the Income Statement are subjective.

What is the ‘amount of revenue gained’ in a period?

What are the relevant expenses?

The tax expense has to be estimated as it is paid 9 months after the balance sheet date.

Profit is a subjective measurement of performance, i.e. the accountant’s estimate of a

company’s net income based on several assumptions. Whereas the movement of cash

during the period is absolute and verifiable, it is objective.

In simple terms, a company either has cash or it doesn’t, but the amount of its profit or loss

for the period can be debatable.

This concept of objectivity can be applied to the cashflow statement, making it more reliable

than the income statement. The question is, is it relevant? How useful to the credit manager

is the cashflow statement?

The cash flow statement of large companies is included in the statutory audit and therefore

shows a ‘true and fair view’ of the company’s cash flows. Additionally it is prepared

according to accounting standards, either FRS1 or IAS 7, and therefore is comparable from

company to company and consistent in its underlying assumptions and presentation.

As previously stated, cash based accounting is not subject to accounting policies or

adjustments and therefore is more objective than other statements. Indeed cash itself is

easily verified by the banks, which are independent to the company. Compare this to the

value of stock/inventory, which is subjective. Total 20 marks

Performance by candidates for this question was second only to the ratio question with an

average of 54%. The majority of students clearly articulated the distinction between profit

and cash. It should be noted that those candidates who failed the assessment didn’t

attempt this question, revealing yet again a lack of preparation for the assessment.

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