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F2
Advanced
Financial
Reporting
Multiple-choice questions concerning a
firms financial performance and position
arent merely a test of your ratio-calculation
skills. You would be well advised to apply
the same systematic approach to any given
scenario featuring a change in ratio values
By Jayne Howson
The F2 exam is an online assessment comprising
questions requiring short answers. Some of these will
be in multiple-choice style, requiring candidates to
choose the right solution from four given options.
The topic Analysis of financial performance and position
takes up 25 per cent of the F2 syllabus. The format of
the exam means that you wont need to write a report
discussing the analysis (as you might have been asked
to do under the previous syllabus). Instead, its likely
that you will be provided with a brief scenario and then
be required either to calculate ratios or to decide what
may have caused certain ratios given in the question to
change in value from one period to the next.

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The latter requirement demands more consideration

in the exam, so lets focus on that. Ill start by looking
at a sample question and then set out a systematic
approach that will arrive at the correct answer.
Sample question
Company H prepares financial statements to 31
December each year. On 31 December 20X4 it had one
million $1 ordinary shares in issue and $750,000 of
8 per cent debentures. The following ratios have been
calculated from its audited financial statements:
Selected financial ratios for company H
Ratio
Return on capital employed
Gearing (debt/equity)

31 December 20X5
15%
30%

31 December 20X4
11%
45%

H records the same operating profit in both years.

Which of the following statements, relating to Hs
activities in the year ended 31 December 20X5 and taken
independently, would explain the movements in both
financial ratios?
A. The revaluation of land upwards.
B. The issue of ordinary shares on the last day of the
accounting period.
C. The repayment of half of the debentures for cash.
D. The bonus issue of ordinary shares from share premium.
A four-step route to the answer
Multiple-choice questions are brief, so its worth bearing
in mind that its unlikely that they will include much, if
any, irrelevant information. We need to do the following:
1. Read the whole question carefully to determine which
ratios are being tested.
2. Think about the information provided in the scenario
and consider why it may have been given.

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3. Write down how each of the relevant ratios is calculated.

4. Take each answer option in turn and think through how
it would affect each ratio.
Lets now apply this approach to the question.
1. Which ratios are being tested? The scenario states that
they are return on capital employed (ROCE) and gearing.
A question will always state how a companys gearing has
been calculated, as alternative methods exist for this.
2. Why has the information been given? The opening
paragraph sets the scene and we should take the following
into account:
H is geared, because it is financed by both equity
(ordinary shares) and debt (debentures).
The companys debt and equity figures are given as at the
end of the previous accounting period. Why would this be
the case? Expect a change in the coming year.
Its operating profits are the same level for both years.
Why would this be stated? Expect a movement in finance
costs and/or tax as one of the answer options.
3. How are the ratios calculated? ROCE is expressed in
percentage terms as operating profit capital employed.
(Operating profit is profit before finance costs and tax;
and capital employed is share capital issued plus reserves
and non-current liabilities, excluding provisions and
deferred tax liabilities.) Gearing is expressed in percentage
terms as debt equity. (Debt is non-current liabilities,
excluding provisions and deferred tax liabilities; and equity
is share capital issued plus reserves.)
4. How does each of the answers given affect each ratio?
When youre working through the four options its important
to consider which figures on the financial statements will be
influenced by the transactions described. Note that the
financial statements relate to activities in the year 20X5, so
youre looking for whether they make the ratios for that
year higher or lower than those in the previous year. In this
question, ROCE has increased while gearing has decreased.

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Jayne Howson is a
freelance lecturer
specialising in financial
management, reporting
and tax, and a marker
for F2

A. The revaluation of land upwards. Land is not subject to

depreciation, so Hs operating profit will not be reduced by
an increase in expenses, but the revaluation reserve will
increase. This is recorded in both capital employed and
equity, affecting both ROCE and gearing. The numerators
of both ratios dont change, while the denominators for
both increase, so both ratios fall in value. You can therefore
conclude that A is not the correct answer.
B. The issue of ordinary shares on the last day of the
accounting period. This would suggest that H doesnt have
time to use the funds to increase its trading activity, so the
operating profit would not be affected this year (although it
may be in future years). The capital employed and the
equity both increase because there is an increase in the
amount of share capital issued. The numerators of both
ROCE and gearing dont change, while the denominators for
both increase, so both ratios fall in value. You can therefore
conclude that B is not the correct answer.
C. The repayment of half of the 8 per cent debentures for
cash. The repayment of debentures reduces the level of
non-current liabilities, thereby reducing the denominator
for ROCE and also the numerator for gearing. The ROCE
increases, therefore, while gearing reduces. Interest
payments are saved, but the operating profit is calculated
before finance costs, so it remains unchanged. You can
therefore conclude that C is the correct answer.
D. The bonus issue of ordinary shares from the share
premium. A bonus issue involves no cash and is simply a
transfer from a reserve to issued share capital. This will not
change the value of either equity or capital employed, so
both ratios are unaffected. You can therefore conclude that
D is not the correct answer.
Working through this question serves to highlight two
important points for F2 students: know your ratio
calculations and always think through the information
provided in each question carefully and systematically.