Unit 5.4 — Financial performance analysis
Learning outcomes (from the 9587 syllabus). This note is complete when every bullet below is covered.
Learning outcomes
- Financial statements: Income Statement; Statement of Financial Position (Balance Sheet); Statement of Cash Flows — purpose, components and uses
- Financial ratios (interpretation and uses): liquidity (working capital/current ratio; quick/acid-test ratio); profitability (gross profit margin; profit margin; return on equity); gearing (debt to equity ratio); investment (dividend yield; earnings per share)
- Cash flow management: define working capital; working capital cycle; management of working capital
Important: you must understand and interpret financial statements and ratios, but you are not required to prepare statements or calculate ratios.
Running example: Swift Logistics reviews its accounts to see how healthy the business is.
Big picture
In plain English: financial analysis is reading a business’s accounts to judge is it profitable, can it pay its bills, and is it too deep in debt? The three statements show profit, position and cash; ratios turn those numbers into meaning.
Analogy: the accounts are a business’s medical report. The Income Statement shows its fitness (profit), the Balance Sheet its body condition (assets and debts), and the Cash Flow Statement its breathing (cash moving in and out). Ratios are the test results.
Core content
1. The three financial statements
| Statement | What it shows | Key components |
|---|---|---|
| Income Statement (Profit or Loss) | Profit over a period | Revenue, cost of sales, gross profit, expenses, operating profit, tax, profit for the year |
| Balance Sheet (Statement of Financial Position) | Assets, liabilities and equity at a point in time | Non-current assets, current assets, current liabilities, non-current liabilities, equity |
| Statement of Cash Flows | Cash inflows and outflows | Operating, investing and financing activities |
Uses: the Income Statement shows profitability; the Balance Sheet shows what the business owns and owes (its position); the Cash Flow Statement shows whether it generates enough cash to survive.
Swift’s Income Statement shows a profit of $60,000, but its Cash Flow Statement reveals that customers pay late, so Swift is short of cash for wages this month. This shows why profit is not the same as cash.
2. Financial ratios (interpretation only)
| Ratio | Formula (for reference) | What it tells you |
|---|---|---|
| Current ratio | Current assets ÷ current liabilities | Can the business pay short-term debts? (around 2:1 is comfortable) |
| Acid-test (quick) ratio | (Current assets − inventory) ÷ current liabilities | Can it pay short-term debts without selling stock? |
| Gross profit margin | Gross profit ÷ revenue | How much profit from sales after direct costs |
| Profit margin | Profit ÷ revenue | Overall profitability of sales |
| Return on equity (ROE) | Profit ÷ shareholders’ equity | Return earned for the owners’ investment |
| Gearing (debt-to-equity) | Debt ÷ equity | How much the business relies on borrowed money |
| Dividend yield | Dividend per share ÷ share price | Income return to shareholders |
| Earnings per share (EPS) | Profit ÷ number of shares | Profit earned per share |
Swift’s current ratio of 1.2 suggests it may struggle to pay short-term debts (less than 2). Its gearing (debt-to-equity) of 0.8 shows moderate debt. Its ROE of 15% shows owners earn a good return on their investment. Together these tell a fuller story than any one number.
3. Cash flow management (working capital)
- Working capital = current assets − current liabilities (the money available for day-to-day running).
- Working capital cycle: cash → buy inventory → sell on credit (receivables) → collect cash. The shorter the cycle, the less cash is tied up.
- Managing working capital: reduce inventory holding, collect money from customers (receivables) faster, and delay paying suppliers (payables) — all to free up cash.
Swift improves its working capital by getting customers to pay in 30 days instead of 60 (faster receivables) and negotiating 45-day terms with its fuel supplier (slower payables). This shortens the cycle and keeps cash available.
Analysis & evaluation points (AO3/AO4)
- Ratios mean little alone — they must be compared over time, against competitors or against benchmarks.
- Profit is not cash — a business can be profitable but run out of cash if customers pay late.
- High gearing is a double-edged sword — it boosts returns when times are good but increases risk when profits fall.
- Too high a current ratio may be wasteful — holding too much cash or stock also has a cost.
Language bank: however · on balance · it depends on · trade-off ·
Worked examples (PEEL)
PEEL = Point → Explain → Example → Link. Use this structure for every written answer.
Worked example 1 — “Explain” (6 marks)
Question: Explain why a business needs to manage its working capital.
- P (Point): Working capital is needed to pay day-to-day bills.
- E (Explain): A business must have enough cash to pay suppliers and wages; if too much cash is tied up in inventory or unpaid customer bills, it can run out of cash.
- E (Example): Swift would struggle to pay wages if customers take 60 days to pay and its own bills are due in 30.
- L (Link): So managing the working capital cycle keeps the business liquid and able to operate.
Worked example 2 — “Evaluate” (12 marks)
Question: Evaluate the usefulness of ratio analysis to a business.
- P (Point): Ratios turn accounts into meaningful signals.
- E (Explain): They summarise profitability, liquidity and debt into comparable numbers, helping managers spot problems and make decisions.
- E (Example): Swift’s falling current ratio warns it of a cash problem before it becomes a crisis.
- L (Link): This supports better decision-making.
- Evaluate (AO4): However, ratios are only as good as the accounts behind them, ignore non-financial factors (reputation, staff morale), and are misleading without comparison. On balance, ratio analysis is useful but must be combined with judgement and other information.
Application bank (Singapore quick reference)
| Idea | Singapore example |
|---|---|
| Published accounts | SGX-listed firms (DBS, Singtel) publishing audited accounts |
| Cash-flow pressure | SMEs facing late payments from corporate clients |
| Gearing | Property firms using high debt (gearing) to fund development |
| Working capital | Retailers managing inventory and supplier credit terms |
Exam technique
- How it appears: a case study gives a statement or ratios and asks you to interpret performance.
- Model skeleton for “interpret a ratio”: state what it measures → what the figure means → whether it is good or bad for this business → what it implies.
- Common pitfalls: calculating ratios when only interpretation is asked (wastes time); quoting a ratio without comparison; confusing profit with cash.
Self-test checklist
Essay practice: “Evaluate the view that profitability ratios are more important than liquidity ratios.” (25 marks)