Ratio Analysis & Interpretation
1. Why Ratio Analysis? (Interpretation)
Final accounts are not the end — they are a means to an end. The real game starts after the income statement & statement of financial position are made: we must interpret them.
Definition: Analysing & interpreting final accounts to judge performance and progress (financial health) of a business — is it improving or worsening day by day?
Compare results with:
- other similar businesses (competitors)
- previous years
- targets & budgets
2. Profit Markup vs Profit Margin
Gross profit can be found two ways: Sales × Margin% = GP or Cost of sales × Markup% = GP (same GP!)
Problem in exams: Question gives sales & a markup % (or gives cost & a margin %). But markup can never be applied on sales, nor margin on cost ⇒ convert first.
Margin → MarkupMargin100 − Margin
3. Profitability Ratios
Aim: is the business earning enough profit? Higher = better for all of these.
① Gross Profit Margin (GP to revenue)
GP = Sales − Cost of sales. Meaning: 25% ⇒ 25 cents gross profit on every $1 of sales.
② Gross Profit Mark-up
Not directly tested, but remember: ÷ revenue = margin, ÷ cost of sales = markup (so markup % > margin %).
③ Net Profit to Sales Ratio (Net Profit Margin)
Net profit = profit for the year = GP + other income − expenses (other income usually not given in ratio questions).
10% ⇒ 10 cents net profit on each $1 of sales. Higher is better.
④ Return on Capital Employed (ROCE)
Owner's capital (equity) + Non-current liabilities (e.g. bank loan) OR Total assets − Current liabilities
Why TA − current liabilities? Total assets − all liabilities = owner's capital only. For capital employed we keep the non-current liabilities, so deduct only current ones.
ROCE = profit before interest ÷ capital employed (owners + outsiders)
ROE = profit after interest ÷ owner's capital only (profit that belongs to owners)
Confusion arises only when both PBI & PAI (or loan interest) are given — first see which ratio is asked!
4. Liquidity Ratios
Liquidity = ability to pay short-term obligations — can current assets cover current liabilities? (cash in bank to pay suppliers, staff, overheads).
① Current Ratio (Working Capital Ratio)
Write as a ratio (2:1), not just "2". Meaning: for every $1 of current liability we have $2 of current assets.
| Current ratio | Value | Comment |
|---|---|---|
| Ideal | 2 : 1 | healthy |
| Maximum | 3 : 1 | above 3 ⇒ idle resources, wasted — better to invest in non-current assets / long-term investments |
| Minimum | 1.5 : 1 | below 1.5 ⇒ liquidity problem; creditors may force closure / bankruptcy |
② Quick Ratio (Acid Test / Liquid Ratio)
Quick assets = cash + bank + (maybe) trade receivables. "Acid test" has nothing to do with chemistry — just a name!
| Quick ratio | Value | Comment |
|---|---|---|
| Ideal | 1 : 1 | $1 quick asset per $1 current liability — very good |
| Maximum | 2 : 1 | above ⇒ resources wasted / not used properly |
| Minimum | 0.7 : 1 | below ⇒ insufficient resources, danger of bankruptcy |
③ Inventory Turnover — in times
Average inventory = Opening + Closing2
Sold goods worth 5 lakh; on average held 100,000 stock ⇒ stock sold & replaced 5 times a year. More times = better.
④ Inventory Turnover — in days (inverse formula)
Meaning: e.g. 60 days ⇒ on average inventory takes 60 days to sell. Fewer days = better (more days ⇒ fewer turns).
e.g. 5 times ⇒ 365 ÷ 5 = 73 days
All other ratios: normal rounding to 2 decimal places unless the examiner says otherwise (25.56% ⇒ 26% only if whole number asked; else 25.56%).
⑤ Expenses to Sales Ratio
5. Handy Relationships (Board Box)
| Turnover / Net sales = | Cost of sales = |
|---|---|
| Sales − Returns inwards OR Cost of sales + Gross profit OR Net profit + Expenses Gross profit = Net sales − Cost of sales |
Net sales − Gross profit OR Inventory turnover × Average stock OR Opening inv + Purchases − Closing inv Net profit = Gross profit − Expenses Expenses = Gross profit − Net profit |
6. Trade Receivable Turnover (Debtors Collection Period)
Meaning: customers take on average 30 days to pay what they owe us.
Is lower or higher better? — two views
| View | Quick payers (fewer days) | Slow payers (more days) |
|---|---|---|
| Liquidity | ✓ more cash, fewer bad debts | ✗ cash tied up, liquidity problem, more chance of bad debts |
| Profitability | ✗ must give high discount allowed (expense); customers annoyed by recovery agents → switch to competitors → sales lost | ✓ happy customers (but see bad debts) |
7. Trade Payable Turnover (Creditors Payment Period)
Only credit purchases! If total purchases given, deduct cash purchases. If purchases missing but cost of sales is given → work back: Purchases = COS + closing inv − opening inv.
Meaning: on average we take 31 days to pay suppliers (some paid early, some late).
Lower or higher? — two views
| View | Pay later (more days) | Pay early (fewer days) |
|---|---|---|
| Liquidity | ✓ supplier credit = free source of finance (no bank loan/overdraft interest) — want it as high as possible | ✗ cash leaves the business sooner |
| Profitability | ✗ suppliers annoyed → refuse supply, demand cash, or charge higher prices ⇒ higher cost ⇒ lower profit | ✓ earn discount received; good relationship; suppliers reliable & trust us |
8. Full Chapter Cheat-Sheet
- Markup→Margin = M/(100+M) | Margin→Markup = M/(100−M) (markup > margin always)
- GP margin = GP/Revenue ×100 | GP markup = GP/COS ×100
- Net profit margin = NP/Revenue ×100 | Expenses to sales = Exp/Net sales ×100
- ROCE = Profit (before interest) / Capital employed ×100; CE = Owner's capital + NCL = TA − CL
- ROE = Profit after interest / Owner's capital ×100
- Current ratio = CA/CL → ideal 2:1, max 3:1, min 1.5:1
- Quick ratio = (CA − Inv)/CL → ideal 1:1, max 2:1, min 0.7:1
- Inventory turnover (times) = COS/Avg inv | (days) = Avg inv/COS ×365 | days = 365÷times
- Receivables days = TR/Credit sales ×365 | Payables days = TP/Credit purchases ×365
- Days ratios → always ROUND UP. Others → 2 d.p. Write liquidity ratios as x : 1.