AAT Level 4 - Professional Diploma in Accounting Financial Statements Interpretation 1 — Questions and Answers
Question 1: A company reports operating profit of £270,000 and interest payable of £45,000. What is the interest cover ratio, and what does it indicate?
- 6 times — the company earns its interest charge 6 times over from operating profit, indicating a comfortable safety margin (Correct answer)
- 6 times — the company is at significant risk of being unable to meet its interest obligations
- 0.17 times — for every £1 of operating profit, £0.17 is absorbed by interest costs
- 4 times — operating profit covers interest payments four times, suggesting moderate risk
Correct answer: 6 times — the company earns its interest charge 6 times over from operating profit, indicating a comfortable safety margin
Interest cover = Operating profit ÷ Interest payable = £270,000 ÷ £45,000 = 6 times. A higher interest cover ratio means the company can comfortably service its debt from operating profit; a ratio of 6 is generally considered healthy and low risk.
Question 2: A company's gross profit margin has remained steady at 40% over two consecutive years, but its net profit margin has declined from 18% to 10%. What is the most likely cause?
- The cost of sales has risen relative to revenue
- Revenue has fallen while selling prices stayed constant
- Distribution, administration, or other operating expenses have increased (Correct answer)
- The company has received less interest income than in the prior year
Correct answer: Distribution, administration, or other operating expenses have increased
Because the gross profit margin is unchanged, the relationship between revenue and cost of sales is stable — so the problem lies below the gross profit line. A falling net profit margin with a stable gross margin points to increased operating overheads such as distribution or administrative expenses.
Question 3: A business has trade receivables of £100,000 and annual credit revenue of £600,000. What is the receivables collection period (to the nearest day)?
- 6 times per year
- 61 days (Correct answer)
- 45 days
- 73 days
Correct answer: 61 days
Receivables collection period = (Trade receivables ÷ Credit revenue) × 365 = (£100,000 ÷ £600,000) × 365 = 60.8, rounded to 61 days. This represents the average number of days the business waits to collect payment from credit customers.
Question 4: A company generates revenue of £1,800,000 and has capital employed (net assets) of £1,200,000. What is the asset turnover ratio and what does it represent?
- 1.5 times — the business generates £1.50 of revenue for every £1 of capital employed (Correct answer)
- 0.67 — for every £1 of revenue earned, 67p of capital is employed
- 1.5 times — the company makes a 150% net profit on its assets
- 2 times — capital employed is exactly half the level of revenue generated
Correct answer: 1.5 times — the business generates £1.50 of revenue for every £1 of capital employed
Asset turnover = Revenue ÷ Capital employed = £1,800,000 ÷ £1,200,000 = 1.5 times. It measures how efficiently a business uses its net assets to generate sales; a higher ratio suggests more efficient use of capital. This ratio is a component of the ROCE calculation (ROCE = Net profit margin × Asset turnover).
Question 5: A company has non-current liabilities of £300,000 and total equity of £700,000. Using the AAT gearing formula, what is the gearing ratio?
- 43% — gearing equals non-current liabilities divided by total equity
- 30% — gearing equals non-current liabilities divided by total capital employed (Correct answer)
- 233% — non-current liabilities are 2.33 times total equity
- 70% — equity represents 70% of funding, confirming low gearing
Correct answer: 30% — gearing equals non-current liabilities divided by total capital employed
The AAT gearing formula is: Non-current liabilities ÷ (Non-current liabilities + Equity) × 100 = £300,000 ÷ £1,000,000 × 100 = 30%. This represents the proportion of long-term funding provided by debt rather than equity; 30% is generally considered low-to-moderate gearing.
Question 6: A company has profit after tax of £240,000 and 800,000 ordinary shares in issue. The current share price is £1.80. What is the price/earnings (P/E) ratio?
- 30p — this is the earnings per share figure, not the P/E ratio
- 0.17 — this represents the earnings yield expressed as a decimal
- 6 — investors are currently paying £6 for every £1 of earnings per share (Correct answer)
- 10 — the market values the company at 10 times its annual earnings
Correct answer: 6 — investors are currently paying £6 for every £1 of earnings per share
First calculate EPS: £240,000 ÷ 800,000 shares = £0.30 (30p) per share. Then P/E = Share price ÷ EPS = £1.80 ÷ £0.30 = 6. A P/E of 6 means investors pay £6 for each £1 of current earnings; a lower P/E may suggest modest growth expectations or that the shares are undervalued relative to peers.
AAT Level 4 - Professional Diploma in Accounting Financial Statements Interpretation 1
A company reports operating profit of £270,000 and interest payable of £45,000.
What is the interest cover ratio, and what does it indicate?