Financial Analysis Question Paper, Answers and Examiner s Comments Level 5 Diploma
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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 Director s 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. 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 wellknown, established company, believe there will be few problems with the receipt of progress payments during the contract. 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 SGC s most recent published financial statements and having spent time reading and analysing them are now ready to advise Technology Solutions Ltd s entrepreneurial owners. You are required to answer the following questions: 9FIA/PQP/5
1. Explain the meaning of the opinion expressed by the auditor of Spring Garden Centres Ltd in the audit report dated 31 st 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) Question aims To test the candidate s 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, can t 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 Centre s 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. 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 (can t 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 company s 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 user s attention to it. N.B. Credit is awarded where candidates use appropriate evidence from the accounts. 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. 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) Question aims To test the candidate s 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 ability to influence the decision made by the credit professional Reliability Understandability Comparability Information that is complete and faithful, so the credit professional can rely on it The significance of the information can be perceived by the credit manager Similarities and differences can by discerned and evaluated by the credit professional, either from year to year, or company to company Any relevant example will be given credit e.g. Its important to the credit decision that information about a company s 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 year s figures. 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 company s 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 company s previous and current year performance is sustainable in the longer term. Inconsistencies in the information provided in the Director s 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. 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 company s going concern. (6 marks) c) Construct a going concern assessment of Spring Garden Centres Ltd using the information available. (10 marks) Question aims To test the candidate s 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 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 don t appear to have liquidity problems. Interest cover of less than 1 means that the company doesn t 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 doesn t 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 don t 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 company s 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 company s liquidity and therefore the likelihood of making payments in the immediate future, would gain marks. 9FIA/PQP/11
4. SGC Ltd has included a Cash Flow Statement for the year ended 31 st 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 Ltd s 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) Question aims To test the candidate s 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. 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 doesn t. 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 won t make business sense to continue. Cash is a better indicator of short-term sustainability as no matter how profitable a company is, if it doesn t have access to cash it can t 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. 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 X 2 X 3 Task a) Calculate these ratios for the current year (2013) from SGC Ltd s Annual Report, showing your workings. (5 marks) b) Using both the industry average ratios and the previous year s 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) Question aims To test the candidate s 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 company s performance and position from the annual report which would be relevant for a credit manager. 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 Debtor Days Creditor days 95 days 18.8 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 company s 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. 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 company s 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 company s bank loans of 5 million are secured on the company s 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 company s 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. 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 wouldn t 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 Director s 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. ---ooo--- 9FIA/PQP/June14/17