I n t e r a c t I v e t e X t foundations in Accountancy/ acca financial accounting (ffa/FA) bpp learning Media is an acca approved Content Provider

PART H: INTERPRETATION OF FINANCIAL STATEMENTS 

 

468

 

FORMULA TO LEARN 

Interest cover = 

charges

Interest

tax

and

interest

before

Profit

 

 

An interest cover of two times or less would be low, and it should really exceed three times before the 

company's interest costs are to be considered within acceptable limits. 

Consider the three companies below.  

 

Company A 

Company B 

Company C 

 

$'000 

$'000 

$'000 

PBIT 

 

40 

 

40 

 

40 

Interest 

 

10 

 

25 

 

30 

Profit before tax 

 

30 

 

15 

 

10 

Taxation  

 

  9 

 

  5 

 3 

Profit after tax 

  

21 

  

10 

  

 7 

The interest cover for these companies is as follows. 

Interest cover = 

PBIT

Interest payable

 

=

$40,000

$10,000

 

$40,000

$25,000

 

$40,000

$30,000

 

 

 

4 times 

1.6 times 

1.33 times 

Both B and C have a low interest cover, which is a warning to ordinary shareholders that their profits are 

highly vulnerable, in percentage terms, to even small changes in PBIT. 

 

 

QUESTION 

Interest cover

 

Returning to the example of Furlong above, what is the company's interest cover? 

ANSWER 

Interest payments should be taken gross, from the note to the accounts, and not net of interest receipts 

as shown in the statement of profit or loss. 

 20X8 

20X7 

PBIT

Interest payable

 = 

$360,245

$18,115

 

$247,011

$21,909

 

 

=  20 times 

= 11 times 

Furlong has more than sufficient interest cover. In view of the company's low gearing, this is not too 

surprising and so we finally obtain a picture of Furlong as a company that does not seem to have a debt 

problem, in spite of its high (although declining) debt ratio.  

 

4.5 Short-term solvency and liquidity  

Profitability is of course an important aspect of a company's performance and gearing or leverage is 

another. Neither, however, addresses directly the key issue of liquidity. 

 EXAM FOCUS POINT 

The ACCA examining team has indicated that interpretation questions are generally well answered. 

However, there was a question on interest cover in a past exam that was poorly answered. The 

question gave an extract from the financial statements and students should have calculated PBIT from 

that information. Many students used the figure for profit before tax and after interest instead.   

BPP Tutor Toolkit Copy

---

CHAPTER 26  

//

  INTERPRETATION OF FINANCIAL STATEMENTS 

 

469 

Liquidity

 is the amount of cash a company can put its hands on quickly to settle its debts (and possibly 

to meet other unforeseen demands for cash payments too). 

 

Liquid funds consist of:  

(a) Cash 

(b) 

Short-term investments for which there is a ready market 

(c) 

Fixed-term deposits with a bank or other financial institution, for example, a six month 

high-interest deposit with a bank 

(d)   Trade receivables (because they will pay what they owe within a reasonably short period of time) 

In summary, liquid assets are current asset items that will or could soon be converted into cash, and 

cash itself. Two common definitions of liquid assets are: 

(a) 

All current assets without exception 

(b) 

All current assets with the exception of inventories 

A company can obtain liquid assets from sources other than sales, such as the issue of shares for cash, a 

new loan and the sale of non-current assets. But a company cannot rely on these at all times and, in 

general, obtaining liquid funds depends on making sales and profits. Even so, profits do not always lead 

to increases in liquidity. This is mainly because funds generated from trading may be immediately 

invested in non-current assets or paid out as dividends. You should refer back to the chapter on 

statements of cash flow to examine this issue. 

The reason why a company needs liquid assets is so that it can meet its debts when they fall due. 

Payments are continually made for operating expenses and other costs, and so there is a cash cycle from 

trading activities of cash coming in from sales and cash going out for expenses.  

4.6 The cash cycle  

To help you to understand liquidity ratios, it is useful to begin with a brief explanation of the cash cycle. 

The cash cycle describes the flow of cash out of a business and back into it again as a result of normal 

trading operations. 

 

Raw materials 

 

 



 

Work in progress

 



 

Finished goods 

 

 

 

 

 

 

 

 

 

 

Payables 

 

 



 

Cash 

 



 

Receivables 

 

 

 

Profit in 

Cash goes out to pay for supplies, wages and salaries and other expenses, although payments can be 

delayed by taking some credit. A business might hold inventory for a while and then sell it. Cash will 

come back into the business from the sales, although customers might delay payment by themselves 

taking some credit. 

The main points about the cash cycle are as follows. 

(a) 

The timing of cash flows in and out of a business does not coincide with the time when sales and 

costs of sales occur. Cash flows out can be postponed by taking credit. Cash flows in can be 

delayed by having receivables. 

(b) 

The time between making a purchase and making a sale also affects cash flows. If inventories 

are held for a long time, the delay between the cash payment for inventory and cash receipts from 

selling them will also be a long one. 

(c) 

Holding inventories and having payables can therefore be seen as two reasons why cash 

receipts are delayed. Another way of saying this is that if a company invests in working capital, 

its cash position will show a corresponding decrease. 

BPP Tutor Toolkit Copy

---