Ratio Analysis and Financial Interpretation

Subject: Accounting
Topic: 10
Cambridge Code: 0452 / 0985 / 7707

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Introduction to Ratios

Ratio - A mathematical relationship between two amounts expressed as a comparison

Purpose of Ratios

1. Evaluate business performance
2. Compare with previous years
3. Compare with other businesses
4. Identify trends
5. Assess financial health
6. Support decision-making

Categories of Ratios

1. Profitability Ratios
2. Liquidity Ratios
3. Efficiency Ratios (Asset Turnover)
4. Solvency Ratios

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Profitability Ratios

1. Gross Profit Margin

Formula: $\text{Gross Profit Margin (\%)} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100$

Interpretation:

• Higher percentage = better (more profit on each sale)
• Below 30% typically concerning
• Indicates pricing strategy and cost control

Example:

• Sales: $100,000
• Gross Profit: $30,000
• Ratio: 30/100 × 100 = 30%

2. Net Profit Margin (Profit Margin)

Formula: $\text{Net Profit Margin (\%)} = \frac{\text{Net Profit}}{\text{Sales}} \times 100$

Interpretation:

• Higher percentage = better management
• Shows percentage of sale that is profit
• Typically 5-15% is acceptable range

Example:

• Sales: $100,000
• Net Profit: $12,000
• Ratio: 12/100 × 100 = 12%

3. Return on Capital Employed (ROCE)

Formula: $\text{ROCE (\%)} = \frac{\text{Net Profit}}{\text{Capital}} \times 100$

Interpretation:

• Shows return earned on owner's investment
• Higher ratio = better
• 15%+ typically considered good
• Benchmarked against interest rates

Example:

• Net Profit: $10,000
• Capital: $50,000
• Ratio: 10/50 × 100 = 20%

4. Return on Assets (ROA)

Formula: $\text{ROA (\%)} = \frac{\text{Net Profit}}{\text{Total Assets}} \times 100$

Interpretation:

• Measures efficiency of asset use
• Higher ratio = better
• Shows profit generated per dollar of assets

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Liquidity Ratios

1. Current Ratio

Formula: $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

Interpretation:

• Measures short-term ability to pay debts
• Ratio of 1.5:1 to 2:1 typically healthy
• Below 1:1 indicates potential difficulty
• Too high may indicate poor asset utilization

Example:

• Current Assets: $50,000
• Current Liabilities: $20,000
• Ratio: 50/20 = 2.5:1
• Interpretation: $2.50 in current assets for each$1 of current liabilities

2. Acid Test Ratio (Quick Ratio)

Formula: $\text{Acid Test} = \frac{\text{Current Assets} - \text{Stock}}{\text{Current Liabilities}}$

Interpretation:

• More stringent than current ratio
• Excludes stock (least liquid)
• Ideal ratio: 1:1
• Shows ability to pay without selling stock

Example:

• Current Assets: $50,000
• Stock: $15,000
• Current Liabilities: $20,000
• Ratio: (50 - 15)/20 = 1.75:1

3. Cash Ratio

Formula: $\text{Cash Ratio} = \frac{\text{Cash}}{\text{Current Liabilities}}$

Interpretation:

• Most conservative ratio
• Shows immediate payment ability
• Low ratio acceptable if receivables convertible

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Efficiency Ratios (Asset Turnover)

1. Asset Turnover

Formula: $\text{Asset Turnover} = \frac{\text{Sales}}{\text{Total Assets}}$

Interpretation:

• Number of times assets are sold during period
• Higher ratio = better asset utilization
• Varies by industry
• More than 1 generally good

Example:

• Sales: $200,000
• Total Assets: $100,000
• Ratio: 200/100 = 2 times
• Assets sold 2 times during period

2. Stock Turnover

Formula: $\text{Stock Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}}$

Interpretation:

• Number of times inventory replaced during period
• Higher ratio = fast-moving goods
• Higher better generally (unless indicates shortage)
• Varies significantly by industry

Example:

• COGS: $150,000
• Average Stock: $20,000
• Ratio: 150/20 = 7.5 times

3. Receivables Turnover

Formula: $\text{Receivables Turnover} = \frac{\text{Sales}}{\text{Average Receivables}}$

Interpretation:

• Times receivables collected during period
• Higher ratio = quick collection
• Lower ratio may indicate collection problems

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Solvency Ratios

1. Debt-to-Equity Ratio

Formula: $\text{Debt to Equity} = \frac{\text{Total Liabilities}}{\text{Capital}}$

Interpretation:

• Measures financial leverage
• Lower ratio = less risky
• Ratio of 1:1 or less typically good
• High ratio indicates high financial risk

Example:

• Total Liabilities: $50,000
• Capital: $100,000
• Ratio: 50/100 = 0.5 (or 1:2)
• $1 debt for every$2 capital

2. Interest Coverage Ratio

Formula: $\text{Interest Coverage} = \frac{\text{Net Profit}}{\text{Interest Paid}}$

Interpretation:

• Times profit covers interest payments
• Higher ratio = better ability to pay interest
• Minimum 2:1 typically acceptable
• Below 1:1 indicates distress

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Worked Example

Financial Information:

• Sales: $500,000
• Gross Profit: $150,000
• Net Profit: $50,000
• Total Assets: $400,000
• Current Assets: $100,000
• Stock: $20,000
• Current Liabilities: $30,000
• Capital: $250,000
• Total Liabilities: $150,000

Ratio Calculations:

Ratio	Calculation	Result
Gross Profit Margin	150/500 × 100	30%
Net Profit Margin	50/500 × 100	10%
ROCE	50/250 × 100	20%
Current Ratio	100/30	3.3:1
Acid Test	(100-20)/30	2.7:1
Asset Turnover	500/400	1.25
Debt to Equity	150/250	0.6:1

Interpretation:

• Profitability: Good margins; reasonable return on capital
• Liquidity: Strong current and acid test ratios; can meet short-term obligations
• Solvency: Conservative debt levels; low financial risk
• Efficiency: Good asset utilization

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Comparing Ratios

Year-on-Year Comparison

Track changes over time to identify trends:

• Improving ratios = positive trend
• Declining ratios = concern
• Significant changes = investigate cause

Inter-Firm Comparison

Compare with competitors:

• Higher profitability = competitive advantage
• Lower liquidity = potential concern
• Similar efficiency = market average

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Key Points to Remember

1. Ratios measure financial performance
2. Profitability shows earning power
3. Liquidity shows ability to pay short-term debts
4. Efficiency shows asset utilization
5. Solvency shows stability and leverage
6. Ratios must be interpreted in context
7. Trends more important than individual ratios

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Practice Questions

1. Calculate these ratios from the following:

   • Sales $300,000, Gross Profit$90,000
   • Net Profit $30,000, Capital$150,000
   • Current Assets $50,000, Current Liabilities$20,000
   • Stock $10,000

2. Interpret the following:

   • Gross Profit Margin 25% (was 30% last year)
   • Current Ratio 2.5:1
   • Asset Turnover 1.5

3. Compare two businesses and identify which is healthier.

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Revision Tips

• Learn the formula for each main ratio
• Understand what each ratio measures
• Know what ratio values are healthy
• Practice calculating ratios from accounts
• Learn how to interpret and compare ratios
• Understand why ratios matter for business