2.1.4 · 40–60 minutes · read, calculate, discuss, review
What you will learn
- Calculate growth, margins and selected performance ratios.
- Compare businesses on a consistent basis.
- Use numerical evidence in a qualified conclusion.
2.1 · Financial Statements
Find the source
Financial Statements · the work you will do
- 1Find the source
- 2Read the profit
- 3Follow the cash
- 4Test the forecast
Before you begin
Company A grows revenue by 20%, while Company B adds more pounds of revenue but grows by only 5%. Which has performed better—and what else would you need to know?
Write your first response before continuing.
Video coming soon · about 4 minutes
The Income Statement: Part 2
Use the narration below while the recording is being made, then try the decisions in this lesson.
Read the full narration
Welcome to On Judgement. Company A grows revenue by 20%, while Company B adds more pounds of revenue but grows by only 5%. Which has performed better—and what else would you need to know? Take a first view. You can change it when you have considered the evidence.
Percentage growth = change divided by the starting value, multiplied by 100. Absolute change answers a different question. CAGR gives a constant annual rate connecting positive endpoints across a stated number of intervals; it does not describe the actual path. A loss or zero starting value needs special care. Separate volume, price, currency, acquisitions and business mix before treating reported growth as market-share success.
Gross, operating and profit-for-year margins divide the relevant profit by revenue. A margin change can reflect pricing, input costs, mix, scale, investment or accounting classification. Compare compatible businesses and periods. Do not borrow a sector average without checking its definition. A low-margin retailer can earn attractive returns through turnover and capital efficiency; a high margin alone does not establish a superior investment.
For the AQA-style measures here, ROCE uses operating profit divided by equity plus non-current liabilities. Gearing uses non-current liabilities divided by the same capital-employed denominator. State the definition because investment analysis also uses other debt and capital measures. A ratio summarises a relationship; it does not tell you whether an asset is productive or a debt maturity is affordable without context.
Write a chain: evidence, plausible mechanism, consequence, counterargument and conditional judgement. Rising revenue with a falling operating margin could reflect a temporary launch cost or a deteriorating competitive position. Ask what data would distinguish those explanations. A valuation multiple such as P/E is a price relationship, not another operating margin. Section 2.2 develops those comparisons.
Let's work through Harbour’s growth and margins. Prior-year revenue was £200m and operating profit £34m. Current revenue is £240m, gross profit £96m, operating profit £36m and net profit £24m. Current equity is £100m; non-current liabilities £50m. Pause here and try the calculation or reasoning before continuing.
Revenue growth = (240 − 200) / 200 = 20%; operating-profit growth = (36 − 34) / 34 = 5.88%. Gross margin = 96/240 = 40%; operating margin = 36/240 = 15%; net margin = 24/240 = 10%. Prior operating margin = 34/200 = 17%; it falls by 2 percentage points, not 2%. ROCE = 36/(100+50) = 24%; gearing = 50/150 = 33.33%.
Revenue growth outpaced profit growth. Investigate mix, costs and investment before deciding whether the margin reduction is temporary.
Now try the choices in this lesson. If your answer changes, identify the reason. Use numerical evidence in a qualified conclusion. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.
Growth needs a denominator
Percentage growth = change divided by the starting value, multiplied by 100. Absolute change answers a different question. CAGR gives a constant annual rate connecting positive endpoints across a stated number of intervals; it does not describe the actual path. A loss or zero starting value needs special care. Separate volume, price, currency, acquisitions and business mix before treating reported growth as market-share success.
Margins reveal conversion
Gross, operating and profit-for-year margins divide the relevant profit by revenue. A margin change can reflect pricing, input costs, mix, scale, investment or accounting classification. Compare compatible businesses and periods. Do not borrow a sector average without checking its definition. A low-margin retailer can earn attractive returns through turnover and capital efficiency; a high margin alone does not establish a superior investment.
Return and financing measures
For the AQA-style measures here, ROCE uses operating profit divided by equity plus non-current liabilities. Gearing uses non-current liabilities divided by the same capital-employed denominator. State the definition because investment analysis also uses other debt and capital measures. A ratio summarises a relationship; it does not tell you whether an asset is productive or a debt maturity is affordable without context.
From ratio to argument
Write a chain: evidence, plausible mechanism, consequence, counterargument and conditional judgement. Rising revenue with a falling operating margin could reflect a temporary launch cost or a deteriorating competitive position. Ask what data would distinguish those explanations. A valuation multiple such as P/E is a price relationship, not another operating margin. Section 2.2 develops those comparisons.
Harbour’s growth and margins
Prior-year revenue was £200m and operating profit £34m. Current revenue is £240m, gross profit £96m, operating profit £36m and net profit £24m. Current equity is £100m; non-current liabilities £50m.
- Revenue growth = (240 − 200) / 200 = 20%; operating-profit growth = (36 − 34) / 34 = 5.88%.
- Gross margin = 96/240 = 40%; operating margin = 36/240 = 15%; net margin = 24/240 = 10%.
- Prior operating margin = 34/200 = 17%; it falls by 2 percentage points, not 2%.
- ROCE = 36/(100+50) = 24%; gearing = 50/150 = 33.33%.
Revenue growth outpaced profit growth. Investigate mix, costs and investment before deciding whether the margin reduction is temporary.
Put it into practice
1. Distinguish two changes
Calculate the relative percentage fall from a 17% margin to 15%, alongside its percentage-point change.
Record your response in your workbook before opening feedback.
Compare with a model response
The change is −2 percentage points; the relative fall is 2/17 = 11.76%. Label the measure to avoid ambiguity.
2. Test a growth story
A firm’s revenue rises from £100m to £121m over two annual intervals. Calculate CAGR and list two reasons not to extrapolate it mechanically.
Record your response in your workbook before opening feedback.
Compare with a model response
CAGR = (121/100)^(1/2) − 1 = 10%. Capacity, competition, acquisition effects or a changing market can make the next period different.
3. Write the judgement
Assess whether Harbour’s 20% revenue growth proves stronger financial performance. Use two calculations and a counterargument.
Record your response in your workbook before opening feedback.
Compare with a model response
Revenue growth is strong, but operating profit grows only 5.88% and margin falls from 17% to 15%. Launch investment could explain a temporary squeeze; evidence on unit economics and future cash conversion is needed.
Jargon buster
Margin
A specified profit divided by revenue.
CAGR
The constant annual growth rate linking stated endpoints.
Percentage point
The arithmetic difference between two percentages.
ROCE
Operating profit relative to the stated capital employed.
Gearing
A financing ratio whose debt and capital definitions must be stated.
Comparability
The extent to which a like-for-like inference is justified.
Knowledge check
Make each choice on the page. Feedback explains the reasoning. Use Try again after revisiting an idea.
AQA connection and further reading
AQA 7138: 3.1.4 financial management; Annexes 6–7 quantitative skills/formulae; AO2 application, AO3 analysis and AO4 evaluation. Detailed accounting policies, EPS and investment multiples are investing enrichment where used.
AQA 7138 specification
Primary curriculum mapping; teacher interpretation, not endorsement.
IAS 7 overview · IFRS Foundation
Accounting classification context. Presentation changes and effective/adoption dates must be checked for real reports.
Free Cash Flow Valuation · CFA Institute
Technical cross-check for consistent claims and valuation formulas; advanced optional reading.
Introduction to Valuation · Aswath Damodaran, NYU
Optional deeper reading on valuation approaches.
Take forward
Calculate growth, margins and selected performance ratios. Compare businesses on a consistent basis. Use numerical evidence in a qualified conclusion.