What you'll learn
Financial statements record what a business earned, what it owns and owes, and where its cash went. Ratio analysis turns those figures into comparisons that mean something, because an absolute profit of $200,000 tells you almost nothing until you know the sales, the capital employed and last year's figure. This guide covers the income statement, the statement of financial position and the cash flow statement, then the four families of ratio — profitability, liquidity, efficiency and gearing — with the formulas, worked calculations and, most importantly, what each result actually tells a user and what it cannot. It sits in Unit 1 Module 3 and supplies the numerate core of the subject.
Key terms and definitions
Income statement — a statement of revenue, costs and profit over a period.
Statement of financial position — a statement of assets, liabilities and capital at a point in time, also called the balance sheet.
Cash flow statement — a statement of cash received and paid over a period.
Gross profit — revenue less cost of sales.
Net profit — gross profit less operating expenses.
Non-current asset — an asset held for more than one year.
Current asset — an asset expected to be converted to cash within a year.
Current liability — an amount due within a year.
Capital employed — the long-term finance in the business: equity plus non-current liabilities.
Working capital — current assets less current liabilities.
Liquidity — the ability to meet short-term obligations as they fall due.
Solvency — the ability to meet all obligations in the long run.
Inventory — stock held for sale or use in production.
Receivables — amounts owed to the business by customers.
Payables — amounts the business owes to suppliers.
Gearing — the proportion of long-term finance that is borrowed.
Core concepts
The income statement
The income statement shows performance over a period.
Revenue − Cost of sales = Gross profit Gross profit − Operating expenses = Net profit (operating profit) Net profit − Interest − Tax = Profit for the year
The distinction between the two profit figures is examined regularly. Gross profit reflects the relationship between selling price and the direct cost of what is sold, so a falling gross margin points to pricing, purchasing or theft. Net profit additionally reflects the overheads, so a healthy gross margin with a weak net margin points to expenses rather than to trading.
The statement of financial position
This shows the position at a single date, and it balances because everything the business has must have been funded from somewhere.
Assets = Liabilities + Capital
Non-current assets — premises, machinery, vehicles — are held for more than a year. Current assets — inventory, receivables, cash — are expected to convert to cash within a year. Current liabilities — payables, overdraft, tax due — fall due within a year. Non-current liabilities — long-term loans, mortgages, debentures — fall due later.
Working capital = current assets − current liabilities, and it is the figure most closely associated with a business failing. A profitable business can run out of cash and stop trading, which is why liquidity is assessed separately from profitability.
The cash flow statement
Profit and cash are not the same. A sale made on credit is profit now and cash later; buying a machine is cash now and cost spread over years. A business can be profitable and insolvent at once, and this is the commonest cause of small-business failure.
The statement separates cash from operations, from investing and from financing. The key reading is whether operating activities generate positive cash, because a business funding its operations from borrowing or asset sales is not sustainable however profitable it appears.
Profitability ratios
Gross profit margin = (Gross profit ÷ Revenue) × 100
Measures the margin on trading before overheads. A fall means price has dropped, direct costs have risen, or the sales mix has shifted to lower-margin lines.
Net profit margin = (Net profit ÷ Revenue) × 100
Measures the margin after overheads. Compare it with the gross margin: if gross is stable and net has fallen, expenses are the problem.
Return on capital employed (ROCE) = (Net profit ÷ Capital employed) × 100
The single most useful profitability measure, because it relates profit to the finance used to generate it. It permits comparison between businesses of different sizes and against the return available elsewhere — a ROCE below what a bank deposit would pay raises the question of why the capital is in the business at all.
Liquidity ratios
Current ratio = Current assets ÷ Current liabilities
Expressed as a ratio to one. A figure around 1.5:1 to 2:1 is often cited as comfortable, but the appropriate level depends on the industry: a supermarket selling for cash and holding fast-moving stock operates safely on far less than a manufacturer with slow inventory.
Acid test (quick ratio) = (Current assets − Inventory) ÷ Current liabilities
Excludes inventory because it is the current asset least reliably converted to cash quickly. Around 1:1 is conventionally regarded as sound. Where the current ratio looks healthy and the acid test does not, the business is holding a great deal of stock — which is exactly the condition that precedes a cash crisis.
A ratio can also be too high: excessive cash sitting idle, or inventory piling up, both represent capital earning nothing.
Efficiency ratios
Inventory turnover = Cost of sales ÷ Average inventory — how many times stock is sold and replaced in a period. Higher is generally better, though too high risks running out.
Receivables days = (Receivables ÷ Revenue) × 365 — how long customers take to pay. Rising receivables days means cash is being collected more slowly, which tightens liquidity even when sales are healthy.
Payables days = (Payables ÷ Cost of sales) × 365 — how long the business takes to pay suppliers. Taking longer improves cash position but risks the supplier relationship.
The three together describe the cash cycle: the time between paying for inputs and being paid by customers. A business can improve liquidity by shortening it at any of the three points.
Gearing
Gearing = (Non-current liabilities ÷ Capital employed) × 100
Above 50% is conventionally high. Interest must be paid before any return to owners, so a highly geared business is exposed in a downturn and to interest-rate rises. The danger depends on how stable the cash flows are — predictable revenue can service debt that would endanger a volatile business.
The limitations of ratio analysis
This is where evaluation marks are earned, and where weaker answers stop.
Ratios describe the past and do not predict the future. They rest on figures prepared under accounting policies that differ between businesses, so comparisons may not be like for like. They ignore everything not in the accounts — staff quality, reputation, customer loyalty, the state of the market. A single year's figure means little without comparison against previous years, competitors or an industry norm. Statements can be presented favourably within the rules. And a position at one date can be arranged to look better than the position throughout the year.
The honest conclusion is that ratios raise the right questions rather than answering them.
Worked examples
Example 1: Profitability (calculation)
Question: "A business reports revenue $800,000, cost of sales $520,000, operating expenses $180,000 and capital employed $500,000. Calculate the gross margin, net margin and ROCE, and comment." (12 marks)
Working.
Gross profit = $800,000 − $520,000 = $280,000 Gross margin = ($280,000 ÷ $800,000) × 100 = 35%
Net profit = $280,000 − $180,000 = $100,000 Net margin = ($100,000 ÷ $800,000) × 100 = 12.5%
ROCE = ($100,000 ÷ $500,000) × 100 = 20%
Comment. A 35% gross margin against a 12.5% net margin means operating expenses absorb $180,000, or 22.5% of revenue — so trading is sound and overheads are where the profit goes. ROCE of 20% is a strong return on the capital committed and comfortably exceeds what the money would earn on deposit. The necessary qualification: one year's figures prove nothing on their own, and the comparison that matters is against last year and against competitors in the same industry.
Example 2: Liquidity (calculation)
Question: "Current assets $240,000 including inventory $150,000; current liabilities $120,000. Calculate the current and acid test ratios and advise." (10 marks)
Working.
Current ratio = $240,000 ÷ $120,000 = 2:1 Acid test = ($240,000 − $150,000) ÷ $120,000 = $90,000 ÷ $120,000 = 0.75:1
Advice. The current ratio of 2:1 looks comfortable, but the acid test of 0.75:1 shows that excluding inventory the business cannot cover its short-term obligations from liquid assets. Inventory is $150,000 of $240,000 current assets — nearly two-thirds — so the apparent health depends entirely on selling stock that may move slowly. Recommend examining inventory turnover to establish how quickly the stock actually sells, reducing stock levels, chasing receivables, and negotiating longer payment terms with suppliers. Note that the appropriate level varies by industry: a retailer selling for cash could operate safely at this acid test, while a manufacturer probably could not.
Example 3: Efficiency and the cash cycle
Question: "Receivables $90,000, revenue $730,000, payables $60,000, cost of sales $480,000. Calculate receivables and payables days, and explain the implication." (10 marks)
Working.
Receivables days = ($90,000 ÷ $730,000) × 365 = 45 days Payables days = ($60,000 ÷ $480,000) × 365 ≈ 46 days
Implication. The business collects from customers in roughly 45 days and pays suppliers in roughly 46, so the two are nearly matched and supplier credit is very nearly funding the credit given to customers. That is a reasonable position, but it is finely balanced: if receivables days lengthen while payables stay fixed, the gap must be funded from cash or an overdraft. Recommend tightening collection — invoicing promptly, chasing overdue accounts, offering an early-payment discount — and note that stretching payables further is available but risks supply and forfeits discounts. Conclude that this pair of ratios matters more to survival than the profit figure does, since businesses fail for want of cash rather than for want of profit.
Common mistakes and how to avoid them
Confusing profit with cash. A profitable business can fail for lack of liquidity.
Confusing gross and net margin. Gross reflects trading; net additionally reflects overheads.
Using revenue instead of capital employed in ROCE. ROCE relates profit to the finance used.
Forgetting to exclude inventory from the acid test. That exclusion is the whole point of the ratio.
Judging a ratio without comparison. One figure alone means nothing; compare over time and against the industry.
Treating a high current ratio as automatically good. Idle cash and piled-up stock earn nothing.
Omitting the limitations. Evaluation marks depend on them.
Presenting a calculation without a comment. The interpretation earns more than the arithmetic.
How this links to your Internal Assessment
If your business will share figures, ratio analysis gives you genuine quantitative content, which most projects lack. Calculate over at least two years, because a trend is analysable and a single figure is not.
Be realistic about access. A public company publishes full accounts; a private company or sole trader may share summary figures in confidence or refuse entirely. Where you only have partial figures, calculate what you can and state plainly which ratios you could not compute and why — that is a limitation, not a failure.
The strongest projects connect a ratio to something observable. If receivables days are long, ask how invoicing and collection actually work and what the manager says about chasing customers. If inventory turnover is low, look at what is sitting in the stockroom. Explaining a number by what you observed is analysis; presenting a table of ratios is not.
Exam technique for financial statements and ratio analysis
State the formula before substituting the numbers; method marks are available even if the arithmetic slips.
Show every step of the working and label the answer with its unit — per cent, ratio to one, or days.
Always comment. A calculated ratio with no interpretation earns a fraction of the marks.
Compare — against the previous year, a competitor, or an industry norm — and say that one figure alone proves nothing.
Pair ratios that illuminate each other: gross with net margin, current with acid test, receivables with payables days.
Give the limitations of ratio analysis in any evaluation question.
Watch the command word: calculate wants the working, analyse wants what the figures show, evaluate wants a judgement including the limitations.
Quick revision summary
The income statement shows revenue less cost of sales as gross profit and less operating expenses as net profit; the statement of financial position shows assets, liabilities and capital at a date and balances because everything held must have been funded; the cash flow statement separates operating, investing and financing cash, and positive operating cash is what makes a business sustainable. Profitability is measured by gross margin, net margin and above all ROCE, which relates profit to the capital employed and so permits comparison between businesses of different sizes. Liquidity is measured by the current ratio and the acid test, which excludes inventory as the least reliably convertible current asset; a healthy current ratio with a weak acid test signals heavy stock holding and often precedes a cash crisis. Efficiency is measured by inventory turnover, receivables days and payables days, which together describe the cash cycle between paying suppliers and being paid by customers. Gearing above 50% is conventionally high, though the danger depends on the stability of cash flows. Throughout, ratios describe the past, rest on differing accounting policies, ignore everything outside the accounts, and mean nothing without comparison — so they raise the right questions rather than answering them.