What you'll learn
Ratio analysis converts the figures in a set of financial statements into relationships that can be compared — against last year, against a competitor, or against what the owner expected. A profit of $54,000 means nothing on its own. A profit of $54,000 on revenue of $512,000 is a net margin of 10.5%, and that can be compared with the 14% the business achieved last year, which turns a number into a question worth asking.
Ratios fall into four families: profitability, liquidity, efficiency and gearing. Each answers a different question. Profitability asks whether the business earns enough from what it does. Liquidity asks whether it can pay what falls due shortly. Efficiency asks how hard the assets are working. Gearing asks how much of the finance is borrowed, and therefore how exposed the business is if trading turns down.
By the end of this topic you should be able to calculate the main ratios in each family, state what each measures, interpret a movement by giving a cause and a consequence rather than restating the figure, and explain the limitations that stop ratio analysis from being the whole answer.
Key terms and definitions
Gross margin — gross profit ÷ revenue × 100. The trading margin before running costs.
Net margin — profit for the year ÷ revenue × 100. What survives after all expenses.
Return on capital employed (ROCE) — profit before interest ÷ capital employed × 100. The headline measure of how well the finance invested is being used.
Current ratio — current assets ÷ current liabilities. Expressed as a ratio to one.
Acid test (quick ratio) — (current assets − inventory) ÷ current liabilities. The same test with the least liquid asset removed.
Inventory turnover — cost of sales ÷ average inventory. How many times the inventory is sold and replaced in the year.
Receivables collection period — (receivables ÷ credit sales) × 365, in days.
Payables payment period — (payables ÷ credit purchases) × 365, in days.
Gearing — non-current liabilities ÷ capital employed × 100. The proportion of long-term finance that is borrowed.
Core concepts
Profitability
Gross margin isolates trading. It moves when selling prices change, when purchase costs change, or when the sales mix shifts towards lower-margin goods. It cannot move because of expenses, since expenses sit below it — a candidate who explains a falling gross margin by saying wages rose has made a structural error, not merely a weak point.
Net margin captures everything below gross profit as well. So a gross margin that holds steady while the net margin falls points squarely at the expenses, and that is a far more useful diagnosis than either figure alone.
ROCE is the measure that ties the two together with the investment. A business can have a healthy margin and a poor ROCE if it is carrying assets it does not need. Use profit before interest in the numerator, because capital employed includes the borrowed finance that the interest pays for — mixing the two produces a figure that means nothing.
Liquidity
The current ratio asks whether short-term resources cover short-term obligations. A ratio around 1.5 to 2 is conventionally described as comfortable, but the sensible reading depends on the trade: a supermarket turning inventory over weekly and selling for cash can operate safely well below that, while a manufacturer holding months of raw material cannot.
The acid test strips out inventory because inventory has to be sold before it becomes cash, and in a downturn that is exactly when it will not sell. A business whose current ratio looks fine but whose acid test is far below it is holding its liquidity in stock, which is a real vulnerability.
Both are snapshots at one date. A business can dress them by delaying payments until just after the year end, which is one reason a trend across several years is worth more than a single figure.
Efficiency
Inventory turnover measures how many times the stock is sold and replaced. A rising figure usually means goods are moving faster; a falling figure suggests overstocking or slow lines. Convert it to days by dividing 365 by the turnover if that is easier to interpret.
The collection and payment periods measure credit control on both sides. A collection period stretching from 40 days to 60 days means cash is arriving more slowly, which puts pressure on the bank balance even while reported profit is unchanged — a distinction worth making explicitly, because profit and cash are not the same thing.
Comparing the two periods is often the most revealing single observation available. A business collecting in 60 days while paying in 30 is financing its customers out of its own working capital.
Gearing
Gearing measures how much of the long-term finance is borrowed. High gearing raises returns to the owner when trading is good, because the lender takes a fixed return and the owner keeps the rest. It raises risk when trading is poor, because the interest must be paid whether or not a profit is made.
There is no universally correct level. What a well-argued answer does is connect the gearing to the stability of the earnings: a business with predictable revenue can carry borrowing that would endanger one whose trade is seasonal or exposed to tourism.
The working capital cycle ties the efficiency ratios together
The three efficiency measures are not separate facts. Put together, they describe how long cash is tied up in the business: the days inventory is held, plus the days customers take to pay, less the days the business takes to pay its suppliers. That figure is the working capital cycle, and it is the number of days the business must finance out of its own resources between paying for goods and being paid for them.
A business holding inventory for 60 days and collecting in 56 days, while paying its suppliers in 30 days, is funding roughly 86 days of trading itself. Lengthening the payment period or shortening either of the other two shortens the cycle and releases cash without any change in profit at all.
This is the most practically useful thing ratio analysis produces for a small business, because each of the three components is something the owner can act on directly — stock levels, credit control, supplier terms. It also makes the profit-versus-cash distinction concrete: a business can be trading profitably and still run out of money if its cycle is long and growing.
Interpretation is cause and consequence
The single largest source of lost marks in this topic is restating the figure. "The current ratio is 1.4, which is lower than last year's 1.9" earns almost nothing. "The current ratio has fallen from 1.9 to 1.4 because the overdraft rose while inventory was unchanged, so the business is now relying on short-term borrowing to fund stock it is not selling" earns the interpretation marks, because it names a cause and states a consequence.
Worked examples
Example 1 — Profitability ratios (6 marks)
Revenue $512,000; gross profit $211,000; profit for the year $54,000; loan interest included in expenses $5,000; capital employed $370,000.
Gross margin = $211,000 ÷ $512,000 × 100 = 41.2%. Net margin = $54,000 ÷ $512,000 × 100 = 10.5%. Profit before interest = $54,000 + $5,000 = $59,000. ROCE = $59,000 ÷ $370,000 × 100 = 15.9%.
Adding the interest back before calculating ROCE matters: using $54,000 would give 14.6% and would understate how well the total finance has been used.
Example 2 — Liquidity ratios (5 marks)
Inventory $52,000; receivables $71,000; prepayments $3,000; bank $18,000; trade payables $44,000; accrued expenses $6,000.
Current assets = $52,000 + $71,000 + $3,000 + $18,000 = $144,000. Current liabilities = $44,000 + $6,000 = $50,000.
Current ratio = $144,000 ÷ $50,000 = 2.88 : 1. Acid test = ($144,000 − $52,000) ÷ $50,000 = $92,000 ÷ $50,000 = 1.84 : 1.
Both are comfortable. The gap between them shows that inventory is a little over a third of current assets, which is unremarkable for a trading business.
Example 3 — Efficiency ratios (6 marks)
Cost of sales $301,000; opening inventory $48,000; closing inventory $52,000; receivables $71,000; credit sales $460,000.
Average inventory = ($48,000 + $52,000) ÷ 2 = $50,000. Inventory turnover = $301,000 ÷ $50,000 = 6.02 times. In days = 365 ÷ 6.02 = 60.6 days. Collection period = ($71,000 ÷ $460,000) × 365 = 56.3 days.
Holding roughly two months of inventory and collecting in under two months is coherent, but a collection period of 56 days against typical terms of 30 days suggests credit control is slipping and is worth a comment.
Example 4 — Interpreting a movement (5 marks)
Gross margin has fallen from 48% to 41.2% while revenue rose from $430,000 to $512,000.
A weak answer states both figures. A strong one says: revenue grew by $82,000, or about 19%, yet each dollar of sales now yields 6.8 cents less gross profit. The likely causes are that purchase prices rose and were not passed on, or that the extra volume was won by discounting. The consequence is that the additional revenue delivered far less additional profit than the growth suggests, so the expansion should be assessed on profit rather than on turnover.
That answer names a cause, quantifies the effect and draws a conclusion, which is what the interpretation marks are for.
Common mistakes and how to avoid them
Restating the figure instead of interpreting it. Every comment needs a cause and a consequence.
Explaining a gross margin movement by reference to expenses. Expenses sit below gross profit and cannot affect it.
Using profit after interest in ROCE. Capital employed includes borrowed finance, so the return must be measured before the cost of that finance.
Using closing inventory instead of average inventory in inventory turnover. Use the average where both figures are given.
Using total revenue in the collection period. Use credit sales; cash sales create no receivable and including them understates the period.
Declaring a ratio good or bad with no benchmark. Compare with the prior year, with a competitor, or with the terms the business itself offers.
Treating a single year's ratio as conclusive. One snapshot can be dressed; a trend is much harder to disguise.
How this links to your Internal Assessment
Ratio analysis is usually where an Internal Assessment earns its interpretation marks. Calculate a small set of ratios well rather than a long list mechanically — four or five, chosen because they bear on the question you set, will beat a table of a dozen with no commentary.
Compare against something. Two years of your own business is the most achievable benchmark and is entirely acceptable; published figures for a listed Caribbean company work if the business you have chosen is comparable in trade. State the benchmark explicitly, because a ratio with nothing to measure it against cannot support a conclusion.
Then close the loop. If the collection period has lengthened, recommend a specific control — statements issued monthly, a discount for settlement within fourteen days, a credit limit per customer — and say what it would cost as well as what it would save. Recommendations that acknowledge a cost read as analysis; recommendations that promise only benefits read as a list.
Exam technique for ratio analysis and interpretation
Questions come in two halves, and they are marked very differently. The calculation half rewards accuracy and a stated formula; the interpretation half rewards reasoning and is where most candidates lose ground.
Always show the formula, then the substitution, then the answer, and give the unit — a percentage, a ratio to one, times, or days. A bare number with no unit cannot be awarded full marks because it is ambiguous.
Mind the command words closely here. Calculate wants the working. Comment on wants one cause and one consequence per ratio. Analyse wants the relationships between ratios drawn out — what a steady gross margin alongside a falling net margin implies. Evaluate or assess wants a judgement, both sides considered, and a conclusion actually stated; an answer that lists strengths and weaknesses and stops has not evaluated anything.
If a question asks about limitations, have three ready: ratios use historical figures and say nothing about the future; they ignore everything not measured in money, such as the quality of management; and different accounting policies make comparison between businesses unreliable.
Quick revision summary
- Four families: profitability, liquidity, efficiency, gearing.
- Gross margin = gross profit ÷ revenue × 100; moves only with prices, costs or mix.
- Net margin = profit for the year ÷ revenue × 100.
- ROCE = profit before interest ÷ capital employed × 100.
- Current ratio = current assets ÷ current liabilities; acid test removes inventory.
- Inventory turnover = cost of sales ÷ average inventory; divide 365 by it for days.
- Collection period = (receivables ÷ credit sales) × 365; payment period uses credit purchases.
- Gearing = non-current liabilities ÷ capital employed × 100; raises both return and risk.
- A steady gross margin with a falling net margin points at expenses.
- Collecting more slowly than paying means the business funds its customers from working capital.
- Interpretation means a cause and a consequence, never a restatement.
- Limitations: historical figures, nothing non-monetary, and policy differences between businesses.