Managers
Use ratios to judge whether objectives are being achieved, resources are controlled efficiently and corrective action is required.
Cambridge International A Level Business · Topic 10.2
Analysis of Published Accounts
Ratio analysis turns figures from published financial statements into evidence about liquidity, profitability, efficiency, long-term finance and shareholder returns. The most important skill is not simply calculating a ratio but interpreting it in context and using comparisons to make a supported judgement.
A LevelFinance & accountingRatio calculationsInterpretation & evaluation
What you need to master
You should be able to calculate and interpret all prescribed ratios, explain what different stakeholders learn from them, compare results over time and against competitors or industry norms, identify limitations of ratio analysis, and suggest realistic actions that could improve a weak ratio without ignoring the possible side effects.
Using ratio analysis
Ratio analysis compares one piece of accounting information with another to help stakeholders judge financial performance. Ratios make raw figures more meaningful because they express relationships: for example, profit relative to revenue, liquid assets relative to short-term debts, or dividends relative to the market price of a share.
Employees
May consider profitability, stability and whether the business appears able to sustain employment and pay.
Shareholders and potential investors
Focus on profitability, long-term financial risk and the return they receive from owning shares.
Suppliers and lenders
Pay particular attention to liquidity, debt and whether the business is likely to meet its obligations.
Government
Published accounts provide evidence relevant to taxation and the financial scale of the business.
Competitors
Can compare margins, efficiency and financing to assess relative performance.
The five ratio families
Good analysis needs comparisons
1. Calculate accuratelyUse the correct formula and units.
2. ComparePrevious years, rivals, industry norms and external conditions.
3. Explain significanceConnect the result to cash, costs, risk, profit or stakeholder decisions.
Four common ways ratios are expressed
Days (e.g. receivables days), percentages (e.g. ROCE), times per year (e.g. inventory turnover) and a ratio (e.g. 1.5:1 current ratio). Always include the correct format in calculations.
Limitations of ratio analysis
- Published accounts are historic; they do not guarantee future performance.
- A single year's ratio may be distorted by unusual events or year-end window dressing.
- Accounting policies, asset valuations and business models may differ, reducing comparability.
- Industry norms vary substantially: a supermarket and a manufacturer should not be judged against the same liquidity benchmark.
- Inflation and changing economic conditions can make comparisons across time misleading.
- Ratios focus mainly on financial information and may not capture product quality, employee skills, brand strength, innovation or customer loyalty.
Liquidity ratios
Liquidity describes a business' ability to meet short-term obligations. A profitable business can still fail if it cannot generate enough cash to pay bills when they fall due, so liquidity matters to managers, suppliers, lenders and shareholders.
Current ratio
Current ratioCurrent assets ÷ Current liabilities
Express the answer as a ratio, for example 1.6:1.
The current ratio compares all current assets, including inventory, with current liabilities. A result of 1.6:1 means the business has $1.60 of current assets for every $1 of short-term debt.
Worked example: current ratio
Current assets = $480,000; current liabilities = $300,000.
Current ratio = $480,000 ÷ $300,000 = 1.6:1.
Acid test / quick ratio
Acid test ratio(Current assets − Inventories) ÷ Current liabilities
This removes inventory because inventory may take time to sell and convert into cash.
Worked example: acid test
Current assets = $480,000; inventory = $150,000; current liabilities = $300,000.
Liquid assets = $480,000 − $150,000 = $330,000.
Acid test = $330,000 ÷ $300,000 = 1.10:1.
Interpreting liquidity
A low result
May signal difficulty paying suppliers, wages, tax or other short-term debts. But cash-based retailers can operate successfully with relatively low ratios because they receive cash rapidly from customers.
A very high result
Is not automatically good. It may indicate excessive cash, slow-moving inventory or other current assets that could have been invested more productively.
Textbook benchmarks are guides, not rules
The text gives around 1.6:1 as a more typical modern current ratio and notes that many businesses can operate with acid-test results near 0.7:1. The appropriate figure depends on the industry, cash cycle, inventory system, supplier relationships and stability of cash flows.
Methods of improving liquidity
Raise long-term cash
Sell non-current assets that are not needed or arrange long-term finance. This can raise current assets without adding current liabilities.
Delay capital spending
Postponing large cash outflows can preserve liquidity, although this may damage capacity or efficiency if essential investment is delayed.
Reduce current liabilities
Using available cash to pay short-term debts can improve the current ratio when the ratio is above 1, but it also reduces cash reserves.
Improve working-capital terms
Collect receivables faster and, where agreed, obtain longer credit from suppliers. This strengthens cash flow but must not damage customer or supplier relationships.
Evaluation: do not automatically recommend the highest liquidity ratio possible. Holding excessive liquid assets has an opportunity cost because cash and slow-moving inventory may earn little return.
Profitability ratios
Profitability ratios compare profit with revenue or the capital available to the business. They help stakeholders judge how effectively managers convert sales and long-term finance into profit.
Return on capital employed (ROCE)Operating profit ÷ Capital employed × 100
Capital employed = share capital + reserves + non-current liabilities.
Gross profit marginGross profit ÷ Revenue × 100
Shows the percentage of revenue left after cost of sales.
Operating profit marginOperating profit ÷ Revenue × 100
Shows the percentage of revenue remaining after operating costs and expenses.
Return on capital employed
ROCE compares operating profit with the long-term finance committed to the business. It is particularly useful for comparing performance over time or with businesses in the same industry and for considering whether the return justifies the capital tied up.
Worked example: ROCE
Operating profit = $720,000; capital employed = $3,000,000.
ROCE = ($720,000 ÷ $3,000,000) × 100 = 24%.
A useful next step is to compare 24% with the business' previous ROCE, competitors and the return available from alternative uses of capital.
Gross and operating profit margins
Worked margin calculation
Revenue = $5,000,000; gross profit = $2,000,000; operating profit = $650,000.
Gross profit margin = $2,000,000 ÷ $5,000,000 × 100 = 40%.
Operating profit margin = $650,000 ÷ $5,000,000 × 100 = 13%.
Stable gross margin
Suggests cost of sales and pricing have not changed dramatically relative to revenue.
→
Falling operating margin
If gross margin is stable but operating margin falls, operating expenses may be rising or being controlled poorly.
Profit is not the same as profitability
A business can earn a larger absolute profit while becoming less profitable relative to sales or capital. For example, expansion can increase total profit but require such a large increase in capital employed that ROCE falls.
Ways to improve profitability
Increase prices
Can raise margins if costs do not rise by as much. But if demand is price elastic, sales volume and total profit could fall.
Reduce costs
Lower input costs, waste or operating expenses can improve margins, provided quality, customer service or long-term capability are not harmed.
Improve the sales mix
Selling more high-margin products can increase overall margins, even if total revenue does not rise substantially.
Reduce capital employed
Selling unused assets or repaying long-term liabilities can improve ROCE if operating profit is maintained.
Evaluation: a high margin is not necessarily evidence of better overall performance if sales volume is very low. A strong answer considers both the percentage margin and what happened to total revenue, profit and market position.
Financial efficiency ratios
Financial efficiency ratios examine how effectively managers control inventories, customer credit and supplier credit. They are especially useful for understanding working-capital management and the cash-conversion cycle.
Inventory turnover
Inventory turnover — times per yearCost of sales ÷ Average inventories held
A higher number means inventory is sold and replaced more frequently.
Inventory turnover — daysAverage inventories held ÷ Cost of sales × 365
A lower number of days generally means inventory moves faster.
Worked example: inventory turnover
Cost of sales = $1,460,000; average inventory = $200,000.
Times per year = $1,460,000 ÷ $200,000 = 7.3 times.
Days = $200,000 ÷ $1,460,000 × 365 = 50 days approximately.
A faster turnover can reduce storage costs and cash tied up in inventory. However, inventory that is too low can cause stock-outs, lost sales and poor customer service. Appropriate turnover varies dramatically across industries.
Trade receivables turnover days
Trade receivables daysTrade receivables ÷ Credit sales × 365
Shows how long customers take, on average, to pay. Cash sales should be excluded from credit sales.
Worked example: receivables days
Trade receivables = $180,000; annual credit sales = $1,800,000.
$180,000 ÷ $1,800,000 × 365 = 36.5 days.
Trade payables turnover days
Trade payables daysTrade payables ÷ Credit purchases × 365
Shows how long the business takes, on average, to pay suppliers. Use credit purchases rather than total cost of sales.
Worked example: payables days
Trade payables = $210,000; annual credit purchases = $1,680,000.
$210,000 ÷ $1,680,000 × 365 = 45.6 days.
Read receivables and payables together
Customers pay in 36.5 days
Cash is collected from customers in a little over five weeks.
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Suppliers are paid in 45.6 days
On average, cash comes in before the business pays suppliers, which can help liquidity.
Improving financial efficiency
Inventory
Improve forecasting, adopt suitable JIT practices, clear obsolete stock and increase sales without building unnecessary inventory.
Receivables
Shorten credit terms, improve credit checks, follow up overdue accounts and use an aged-receivables analysis to target slow payers.
Payables
Negotiate longer supplier credit where possible. Simply paying late without agreement can damage trust, supply reliability and credit terms.
Balance matters
Reducing every working-capital figure is not automatically efficient. The objective is to maintain enough inventory and attractive credit terms while avoiding unnecessary cash being tied up.
Evaluation: if payables days are shorter than receivables days, the business may have to pay suppliers before collecting from customers. This can place pressure on liquidity, but the effect depends on cash sales, inventory needs and other cash flows.
Gearing ratios
Gearing examines the long-term financial structure of the business by comparing non-current liabilities with total capital employed.
Gearing ratioNon-current liabilities ÷ Capital employed × 100
Capital employed = share capital + reserves + non-current liabilities.
Worked example: gearing
Non-current liabilities = $1.4 million; capital employed = $2.5 million.
Gearing = $1.4m ÷ $2.5m × 100 = 56%.
Using the textbook's broad guide, this is above the 50% dividing line and would be described as relatively highly geared.
Why high gearing can be risky
Interest payments are contractual. If interest rates rise or cash flows weaken, a heavily borrowed business may find finance costs difficult to meet. High debt can also reduce the amount available for dividends.
Why high gearing can be acceptable
A fast-growing business with stable cash flows may deliberately borrow to finance profitable expansion. Debt can allow growth without issuing more shares and diluting existing ownership.
Why low gearing can be attractive
Lower borrowing usually means lower exposure to interest-rate changes and lower fixed finance commitments.
Why very low gearing can be criticised
Managers may be too cautious and could be missing profitable investment opportunities that could have been financed with sensible borrowing.
Improving a high gearing ratio
- Repay non-current loans from cash generated by the business or asset sales.
- Raise more equity by issuing ordinary shares, increasing capital employed without increasing long-term debt.
- Retain more profit to build reserves, although this may reduce dividends in the short term.
Evaluation: 50% is a broad guide rather than a universal rule. The sustainability of gearing depends on the stability of cash flows, interest rates, profitability, asset backing, growth opportunities and the industry.
Investment ratios
Investment ratios are mainly used by existing and potential shareholders. Investors can earn returns through dividend income and through a capital gain if the market price of their shares rises.
Dividend per share (DPS)Total annual dividends ÷ Number of issued shares
Usually expressed in cents or pence per share.
Dividend yieldDividend per share ÷ Market price per share × 100
Compares dividend income with the price paid for a share.
Dividend coverProfit for the year ÷ Annual dividend
Shows how many times profit covers the dividend payment.
Earnings per share (EPS)Profit for the year ÷ Number of issued shares
Shows the amount of annual profit attributable to each share.
Price–earnings ratio (P/E)Current share price ÷ Earnings per share
Shows how much investors are paying for each unit of annual earnings.
Worked investment-ratio example
A company has profit for the year of $12 million, pays annual dividends of $4.8 million, has 24 million shares in issue, and its market price is $3.20 per share.
DPS = $4.8m ÷ 24m = $0.20.
Dividend yield = $0.20 ÷ $3.20 × 100 = 6.25%.
Dividend cover = $12m ÷ $4.8m = 2.5 times.
EPS = $12m ÷ 24m = $0.50.
P/E = $3.20 ÷ $0.50 = 6.4.
Interpreting the ratios
DPS
A higher DPS gives more cash income per share, but a business that pays out too much may retain too little for investment and future growth.
Dividend yield
Useful when comparing dividend income with the price of the share. It can change because the dividend changes or simply because the market share price moves.
Dividend cover
Higher cover means the dividend is more comfortably supported by current profits. The text gives around 2 times as a generally safe guide and below 1.5 as more risky, though profit stability matters.
P/E ratio
A higher P/E often indicates stronger investor expectations of future earnings growth. Comparisons are most meaningful within the same industry and over time.
P/E context
The textbook notes an approximate average P/E of 14–15, but P/E ratios vary substantially by industry, growth expectations, interest rates and investor sentiment. A high P/E is not automatically good and a low P/E is not automatically bad.
Improving shareholder returns
Stronger business performance
Sustained growth in profits can support higher dividends and may improve market confidence and the share price.
Increase dividends
Raises cash income to shareholders but leaves less retained profit for future investment.
Share buy-backs
A company can use surplus cash to repurchase some of its shares. With fewer shares outstanding, measures such as EPS and DPS may increase, though the decision must be financially justified.
Retain and reinvest
Some long-term investors may accept a lower dividend today if retained profit finances projects that raise future earnings and the share price.
Overall approach to published accounts
Current ratio + acid test
ROCE, margins, inventory, receivables, payables
Gearing + shareholder ratios
Evaluation: shareholders do not all have the same objectives. An income-focused investor may prefer a high dividend yield, while a long-term growth investor may prefer profits to be retained. Use the investor's objective when judging a ratio.
Final exam rule: never judge from one ratio
Combine ratios. A company may have strong ROCE but weak liquidity; high dividend yield but low dividend cover; low gearing but slow growth. A balanced conclusion weighs several indicators and the business context.
10.2 revision checklist
Questions open in a pop-up. Each answer is marked immediately, with an explanation so you know why it is correct or incorrect.