Ratio analysis
Profitability, liquidity, efficiency and gearing ratios, and how to interpret them.
ACCA exams this helps with: FA Financial Accounting FR Financial Reporting See the ACCA map
New to this topic?
What it is: A ratio compares one figure with another figure, usually as a percentage or as “x : 1”.
Why you need it: A figure on its own does not tell you if it is good or bad. £50,000 profit on £100,000 of sales is very good. £50,000 profit on £10 million of sales is poor. Ratios let you compare years and compare businesses of different sizes.
What you do: Use the formula. Work out the ratio for this year and last year. Say whether it went up or down, and give a reason from the figures.
Example. Sales £100,000. Gross profit £40,000. Gross margin = £40,000 ÷ £100,000 × 100 = 40%. This means 40p of every £1 of sales is left after paying for the goods.
Key words
- Margin
- Profit as a percentage of the selling price.Example: Selling for £125 something that cost £100: profit £25 ÷ price £125 = 20% margin.
- Liquidity
- Whether a business has enough cash, or items that will soon become cash, to pay its bills when they are due.Example: Current assets £25,000 and current liabilities £12,500 give a current ratio of 2 : 1, which shows good liquidity.
- ROCE
- Return on capital employed: operating profit as a percentage of the long-term money invested in the business (equity plus long-term loans).Example: Operating profit £18,000 ÷ capital employed £120,000 = 15% ROCE.
- Gearing
- How much of a business’s long-term funding comes from borrowing, as a percentage.Example: Loans £40,000 and equity £60,000: gearing = 40,000 ÷ 100,000 = 40%.
Learn
A ratio compares one figure in the accounts with another. For every ratio, write four things: the formula, the workings, the answer with its unit, and what it means.
| Group | Ratio | Formula | Unit |
|---|---|---|---|
| Profitability (how much profit) | Gross profit margin | Gross profit ÷ Revenue × 100 | % |
| Operating profit margin | Operating profit ÷ Revenue × 100 | % | |
| ROCE (return on capital employed) | Operating profit ÷ Capital employed × 100 | % | |
| Liquidity (can it pay its bills) | Current ratio | Current assets ÷ Current liabilities | : 1 |
| Quick (acid test) ratio | (Current assets − Inventory) ÷ Current liabilities | : 1 | |
| Efficiency (how fast cash moves) | Receivables days | Trade receivables ÷ Revenue × 365 | days |
| Payables days | Trade payables ÷ Cost of sales × 365 | days | |
| Inventory days | Inventory ÷ Cost of sales × 365 | days | |
| Gearing (how much is borrowed) | Gearing | Non-current liabilities ÷ (Equity + Non-current liabilities) × 100 | % |
| Interest cover | Operating profit ÷ Finance costs | times |
Example: Current assets £60,000. Current liabilities £40,000. Current ratio = £60,000 ÷ £40,000 = 1.5 : 1. The business has £1.50 of current assets for every £1 it must pay within 12 months.
Explaining a ratio
One ratio on its own tells you very little. Do these three things:
- Compare it with last year, a competitor or the industry average.
- Give a likely reason for the change, using the figures.
- Say what it leads to.
Example: “Receivables days went up from 35 to 52. Customers are taking longer to pay, which may mean weaker credit control. Cash is coming in more slowly, so the business may find it harder to pay its bills.”
Watch it explained
Press play to watch the animation, or step through it at your own pace with the arrows.
Videos from YouTube tutors
These videos are made by independent tutors on YouTube, not by Trial Balance. Some use US terms or older exam names (for example F7 for FR), but the principles are the same.
Worked example
Using revenue £80,000, gross profit £40,000, operating profit £16,000, current assets £13,000, current liabilities £4,000, equity £29,000 and a £10,000 long-term loan:
| Ratio | Workings | Result | Interpretation |
|---|---|---|---|
| Current ratio | 13,000 ÷ 4,000 | 3.25 : 1 | Very liquid, possibly holding too much idle cash or inventory. |
| Gross profit margin | 40,000 ÷ 80,000 × 100 | 50.0% | Half of each £1 of sales is left after direct costs. |
| ROCE | 16,000 ÷ (29,000 + 10,000) × 100 | 41.0% | A strong return on the long-term capital invested. |
Practice questions
Type or choose your answers, then press Check answer. Questions with a New numbers button can be repeated with different figures.