Ratio analysis: worked examples

Method and where the marks are

Ratio analysis turns the figures in the financial statements into measures of how well a business performs and how safely it is financed. The examiner rewards three things about equally: choosing the right ratio, calculating it with the right components, and interpreting what the number means.

Many students do the arithmetic and stop, which throws away half the marks. Treat every ratio question as calculate, then comment.

Group the ratios by what they measure. Profitability ratios include gross profit margin (gross profit ÷ sales × 100) and profit margin (profit for the year ÷ sales × 100). They also include return on capital employed, ROCE (profit before interest ÷ capital employed × 100).

Liquidity ratios include the current ratio (current assets ÷ current liabilities) and the acid-test, or quick, ratio (current assets less inventory, ÷ current liabilities). Efficiency ratios include the rate of inventory turnover and the trade receivables and trade payables periods in days.

Learn each formula precisely. The difference between gross profit and profit for the year, or between current assets with and without inventory, is exactly what is tested.

Use the right components every time. A correct formula with the wrong numbers still scores badly. Capital employed usually means the owner's capital plus long-term liabilities.

Use the same definition throughout an answer. Inventory turnover is cost of sales ÷ average inventory, not sales ÷ inventory. Average inventory is (opening + closing) ÷ 2 when both are given.

The receivables period is trade receivables ÷ credit sales × 365 days. It uses credit sales, not total sales, if the question separates them. State the units.

A margin is a percentage. A current ratio is written as a figure to one, such as 2 : 1.

Turnover is a number of times. Collection periods are in days.

Interpretation shows understanding, so compare the number with something: last year, another business or a sensible benchmark. A current ratio that fell from 2.1 : 1 to 1.3 : 1 suggests weaker liquidity and possible trouble paying suppliers. A gross margin that slipped from 40% to 32% might mean selling prices were cut, purchase costs rose or the sales mix changed.

A receivables period that stretched from 30 to 55 days suggests weaker credit control and a risk to cash flow. Do not just say a ratio went up or down. Say what the change means and suggest a plausible cause.

The examiner often expects you to link ratios. The acid-test ratio leaves out inventory because it is the least liquid current asset. A healthy current ratio with a weak acid-test ratio points to money tied up in unsold goods.

A long receivables period with a short payables period squeezes cash, because the business pays suppliers faster than customers pay it. A rising margin with a falling ROCE means the capital base has grown faster than profit. Connecting two ratios earns higher-level marks.

Know the limits of ratios, because evaluation questions ask for them. They use historical figures, and past performance is not a promise of future results. They ignore rising prices and non-financial factors such as staff quality or reputation.

Differences in accounting policy can make businesses hard to compare. A single ratio in isolation means little. It needs a comparison.

Avoid these calculation slips. Do not use sales instead of cost of sales for inventory turnover. Do not mix up mark-up and margin. Remember to multiply by 100, and use an average inventory when it is available. State the formula, substitute the figures with units, then write a sentence or two comparing and explaining the result. That captures the calculation marks and the interpretation marks together.

If your ratio answers calculate well but lose marks on comment, one of our teachers can practise interpretation with you on past-paper questions until the comments come easily. Book a trial class