Explain how the Topic 3.5 ratios interrelate
Connect operating efficiency, working-capital funding, borrowing risk and shareholder returns in one account.
Exam scope and assessment notes
Cambridge International AS & A Level Accounting 9706, 2026–2028 syllabus, Version 2. Use the ratio formulae in the syllabus appendix exactly; Cambridge states these are the only formulae accepted. Use year-end balances where appropriate unless the question specifies averages, and round to the requested number of decimal places. Practice is self-checked, not an official Cambridge grade. Full timed Papers 1–4 and human subject-teacher review remain outstanding.
Before you begin
- Use the AS Topic 1.6 ratio, financial-statement and stakeholder skills. These lessons add only the A Level ratios and interpretation required by Topic 3.5.
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
What two figures determine EPS?
What you will learn
- Link working-capital measures to borrowing needs
- Link gearing and interest cover to financial risk
- Connect EPS, P/E and dividend measures without conflating them
Trace the operating-to-financing link
A longer working capital cycle can tie up more cash. If that need is financed with non-current borrowing, gearing may rise and interest payable may increase; if operating profit does not rise, interest cover may fall.
These interrelationships are possible, not guaranteed causal results. Working capital may be financed through equity or existing cash, and borrowing may fund growth that later improves operations. Verify timing and cause with the accounts and business evidence.
Trace the earnings-to-investor link
Profit and issued shares determine EPS. Market price divided by EPS gives P/E. Annual ordinary dividend and share count determine DPS; DPS relative to market price gives yield; profit available relative to annual ordinary dividend gives cover.
A dividend can affect retained funds and future investment, while share price movements affect P/E and yield differently. Analyse the connected measures together, but keep each formula, unit and stakeholder purpose distinct.
Pause and explain
Why can dividend yield rise even when DPS is unchanged?
Worked example
A company shortens its cycle but also borrows for expansion. Gearing rises, cover is stable, EPS rises and dividend cover falls. Identify two plausible links and one question to investigate.
Show the worked solution
- The shorter cycle may release cash, while new borrowing raises gearing to fund expansion.
- Stable interest cover suggests operating-profit coverage has not changed relative to interest, while EPS growth may reflect stronger profit per share.
- Falling dividend cover may reflect a faster dividend increase; check the payout, cash flow, share count and investment return.
Answer The ratios describe different parts of performance and finance. Investigate the causes, timing and sustainability rather than assuming one change caused all the others.
Try a topic test
Choose Easy, Normal or Difficult. Save your answers and open worked review after finishing.
Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
A longer working-capital cycle leads to higher borrowing. Describe possible effects on gearing and interest cover, including one caveat.
Give me a hint
Trace the borrowing to capital mix and interest, then avoid assuming profit is fixed.
Compare my reasoning
- More non-current liabilities may raise gearing if other capital is unchanged.
- Higher interest may lower cover if operating profit does not rise by the same proportion.
- A stronger return from borrowing could later increase operating profit, so review the investment timing and cash flow.
Gearing may rise and cover may fall, but the outcome depends on capital changes, operating returns and timing.
Look for these in your work
- Link liabilities to gearing.
- Link interest with cover conditionally.
- State an evidence-based caveat about returns and timing.
EPS rises 10%, DPS is unchanged, share price falls 5% and dividend cover rises. Identify the direct arithmetic effects on P/E and yield, assuming the other inputs stay as stated.
Give me a hint
P/E uses price/EPS; yield uses DPS/price.
Compare my reasoning
- Higher EPS and a lower price both reduce P/E, if EPS stays positive.
- With DPS unchanged and price 5% lower, dividend yield rises.
- Higher dividend cover is consistent with more profit available per annual dividend, but it is not a cash guarantee.
P/E falls and dividend yield rises under the stated conditions; higher cover increases the accounting-profit buffer but does not prove cash affordability.
Look for these in your work
- Apply EPS and price movements to P/E.
- Apply the price fall to yield while DPS stays fixed.
- Qualify what rising cover does and does not prove.
A new share issue funds a project. Total profit rises slightly, EPS falls, gearing falls, and P/E rises. Explain why these results can coexist.
Give me a hint
Consider the larger share denominator, lower debt share and market price response.
Compare my reasoning
- Issued shares may rise proportionately more than profit, lowering EPS.
- New equity can reduce gearing if it increases share capital while liabilities are unchanged.
- P/E can rise if the market price rises relative to EPS; investigate market expectations and the project's future performance.
More shares can reduce EPS, equity funding can lower gearing and a price increase can raise P/E. These ratios respond to different inputs and may move together in this way.
Look for these in your work
- Explain EPS using profit and share-count changes.
- Explain gearing using capital structure.
- Explain P/E using both price and EPS.
Common mistakes
- Claiming a causal link from ratios alone
- Combining different units into one score
- Ignoring share issues or market-price changes
What can you explain now?
If a longer cycle is financed by new borrowing, which pair may show the financing consequences?
Compare with the explanation
Gearing and interest cover
More borrowing can affect gearing and interest obligations may affect cover, though the actual movement needs evidence.
After trying it yourself, choose your next review. This is your self-assessment.
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Make it stick
Give one plausible chain connecting working capital, borrowing and interest cover, and name one caveat.
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.