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Help With AAT Level 4 Ratio Analysis – Part 1

Stuck with Ratio Analysis in AAT Level 4 (Professional Level)? Then help is at hand…

At Professional Level (Level 4), all of the mandatory units and some of the optional units include questions on ratio analysis.  Students generally have no difficulty in calculating the ratios (once they have memorised all those formulae) but when it comes to writing about ratios, things get more tricky.

In ratio analysis we use calculations of financial ratios to make judgements about the financial performance of a business.  This need to make judgements allows students to demonstrate the Level 4 skill of evaluation, one reason why ratio analysis is such a popular topic with examiners.

Students frequently throw away marks in exam questions by failing to address some basic requirements.

So let’s look at what is needed to maximise your marks:

Write about each ratio.  Students sometimes try to discuss the business as a whole, without looking at the individual ratios, but you will not gain many marks if you follow that approach.   You must ensure you write a paragraph about each ratio in turn.

Be aware of the ratio groups.  AAT have recently revised the Professional Level specification to give much more information about the specific information required.  The specification for Financial Statements of Limited Companies helpfully lists the required ratios in groups: Profitability, Liquidity, Use of Resources and Financial Position.  You must know what each ratio measures and other ratios in the same group.

For each ratio your paragraph of analysis should:

State what each ratio shows.  For example, the Operating Profit ratio shows how effectively the business manages its running costs.

State whether the ratio has improved or deteriorated.   This is the section where students  frequently lose marks.  It is not enough to state that a ratio has increased or decreased.  Is an increase a good thing or a bad thing?  Using these terms, or saying that a ratio has ‘gone up’ or ‘gone down’ does not show any judgement.  You must clearly demonstrate whether a ratio is better or worse than last year, or the industry standard, or whatever else you are measuring it against.  Therefore, you should always use evaluative terms such as ‘improved’ or ‘deteriorated’.

Explain the change in the ratio.  In other words, how has the change in the ratio affected business performance.  Too many students omit this section of the analysis altogether.  It is certainly the hardest part, but there are some obvious points that can be made.  For example, if the current ratio increases from 1.2:1 in year 1 to 1.8:1 in year 2, this suggests that the business has more current assets available to pay its immediate debts and is therefore more solvent in year 2.  This may seem an obvious point, but it cannot be emphasised enough how important it is to state the obvious in your exam answers.

Also…

Try to explain the possible commercial reasons behind a movement in a ratio. If the gross profit margin has improved, don’t just say “the gross profit margin has gone up because gross profit has increased whilst turnover has stayed the same” – that’s just the algebra!

Instead say “The increase in the gross profit margin could have been caused by a price increase during the year” or, “by sourcing new materials from a new supplier offering lower prices”

Remember that writing answers to exam questions is a skill and like all skills, it will improve with practice.  Hopefully, the tips above will help you to feel more confident about your written answers.  In Part 2 of this blog we will give an example of a written ratio analysis.