Domain VII: Financial Management

• Topic 01

  Financial Statements — Balance Sheet, Income Statement, Cash Flow

  42 questions
• Topic 02

  Basic Financial Ratios and Analytical Techniques

  39 questions
• Topic 03

  Budgeting and Variance Analysis

  30 questions
• Topic 04

  Capital Budgeting Concepts (NPV, IRR, Payback)

  33 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. What is the interest coverage ratio and at what level does it become a concern for creditors?

   • A
     Interest Coverage Ratio = Current Assets / Interest Expense; it measures short-term liquidity relative to annual interest costs
   • B
     Interest Coverage Ratio = EBIT / Interest Expense; it measures how many times earnings cover interest payments; a ratio below 2 is generally considered concerning for creditors as it indicates thin earnings coverage of debt service
     Correct answer
   • C
     Interest Coverage Ratio = Operating Cash Flow / Total Liabilities; it measures how well all obligations are covered by cash flow; below 0.5 is concerning
   • D
     Interest Coverage Ratio = Gross Profit / Finance Costs; it measures whether gross profit alone can service debt; a ratio above 5 is always concerning
   Explanation

   Interest Coverage Ratio = EBIT (Earnings Before Interest and Tax) / Interest Expense. It answers the question: how many times over can the entity pay its interest charges from its operating earnings? A ratio of 3x means earnings are three times greater than interest costs. As a rule of thumb, below 2x is considered concerning for creditors because a moderate decline in earnings could leave the entity unable to service its debt. Below 1x means the entity cannot cover its interest from earnings at all, which is a serious going concern indicator. This ratio is often included in bank loan covenants, making it a direct internal audit interest for covenant compliance reviews.

2. An entity's accounts receivable turnover has declined from 8.2 to 5.1 over two years while revenue has grown 18% and credit terms remain unchanged at 30 days. Calculate the days sales outstanding for each year and explain what this pattern indicates from an audit perspective.

   • A
     DSO Year 1 = 44.5 days and DSO Year 2 = 71.6 days; this improvement in collection efficiency is positive and requires no audit investigation
   • B
     DSO Year 1 = 365/8.2 = 44.5 days; DSO Year 2 = 365/5.1 = 71.6 days; against a 30-day credit term this means average collection has extended from 15 days beyond terms to 42 days beyond terms; combined with revenue growth, this is a strong indicator of fictitious revenue, declining receivables quality, or customers in financial difficulty — the auditor should perform detailed receivables ageing, direct confirmation, and review of post-period cash receipts
     Correct answer
   • C
     DSO Year 1 = 8.2 days and DSO Year 2 = 5.1 days; the declining ratio directly gives the days outstanding, confirming collection has shortened
   • D
     DSO improvement from 44.5 to 71.6 days confirms that the entity has extended credit terms to win more revenue; no audit concern arises
   Explanation

   DSO = 365 / AR Turnover. Year 1: 365 / 8.2 = 44.5 days. Year 2: 365 / 5.1 = 71.6 days. Standard credit terms are 30 days. In Year 1, customers took 44.5 days on average — 14.5 days beyond terms. In Year 2, customers took 71.6 days — 41.6 days beyond terms. This deterioration, against a backdrop of 18% revenue growth, is highly suspicious: if revenue is real and credit terms are unchanged, why are customers paying so much more slowly? Possible explanations include: (1) Fictitious revenue recorded but not collected because no real customer exists; (2) Revenue recognised before delivery, so customers dispute or delay payment; (3) Genuine customer financial distress. The auditor should: perform receivables ageing analysis; send direct confirmations to material customers; test post-period cash receipts (amounts collected after year-end); and critically review the adequacy of bad debt provisions.

3. Which IIA Standard requires internal auditors to use appropriate analytical techniques such as variance analysis?

   • A
     IIA Standard 2410 — Criteria for Communicating
   • B
     IIA Standard 2200 — Engagement Planning
   • C
     IIA Standard 2100 — Nature of Work
   • D
     IIA Standard 2320 — Analysis and Evaluation
     Correct answer
   Explanation

   IIA Standard 2320 — Analysis and Evaluation requires internal auditors to use appropriate analytical techniques to identify patterns, trends, relationships, and anomalies. Variance analysis — comparing actual results to budget and investigating the reasons for significant differences — is a directly applicable technique under this standard. Other standards are related but have different focuses: Standard 2100 defines the nature of internal audit work; Standard 2200 governs engagement planning; Standard 2410 covers communicating audit results; Standard 1210 addresses proficiency requirements; Standard 2120 addresses risk management assessment.