Accounting Ratios and Interpretation
Ratios turn raw financial statement figures into meaningful comparisons — is the business profitable, can it pay its bills, and is it managing its resources efficiently?
1. Profitability Ratios
| Ratio | Formula |
|---|---|
| Gross profit margin | (Gross profit / Revenue) × 100 |
| Mark-up | (Gross profit / Cost of sales) × 100 |
| Profit margin | (Profit for the year / Revenue) × 100 |
| ROCE | (Profit for the year / Capital employed) × 100 |
Gross profit = 100,000 − 60,000 = $40,000.
Gross profit margin = 40,000/100,000 × 100 = 40%. Mark-up = 40,000/60,000 × 100 = 66.7%.
Profit margin = 20,000/100,000 × 100 = 20%. ROCE = 20,000/150,000 × 100 = 13.3%
2. Liquidity Ratios
| Ratio | Formula |
|---|---|
| Current ratio | Current assets : Current liabilities |
| Acid-test (liquid) ratio | (Current assets − Inventory) : Current liabilities |
Current ratio = 30,000 : 15,000 = 2 : 1.
Acid-test ratio = (30,000 − 10,000) : 15,000 = 20,000 : 15,000 = 1.33 : 1
3. Efficiency Ratios
| Ratio | Formula |
|---|---|
| Inventory turnover (times) | Cost of sales / Average inventory |
| Inventory turnover (days) | (Average inventory / Cost of sales) × 365 |
| Trade receivables turnover (days) | (Trade receivables / Credit sales) × 365 |
| Trade payables turnover (days) | (Trade payables / Credit purchases) × 365 |
Times = 60,000/8,000 = 7.5 times. Days = 8,000/60,000 × 365 = 48.7 days
4. Interpretation
Ratios are most useful when compared — against previous years, against similar businesses, or against a target. Always explain WHY a ratio has changed, not just that it has. Note: cash and profit are different — profit includes non-cash items (like depreciation and accrued income/expenses), while cash reflects only actual money movements. A profitable business can still run out of cash.
- Mixing up mark-up (based on cost of sales) with margin (based on revenue) — they describe the same gross profit, but as different percentages.
- Forgetting to use AVERAGE inventory (opening + closing)/2 for inventory turnover, rather than just the closing figure, when both are available.
- Just stating a ratio has “improved” or “worsened” without explaining a plausible business reason why.
Key Vocabulary Recap
Syllabus Reference
Practice questions
Accounting Ratios and Interpretation — Practice
Covers: profitability, liquidity, and efficiency ratios, and interpretation. 10 questions.
Revenue is $100,000 and cost of sales is $60,000. Calculate the gross profit margin and the mark-up.
Profit for the year is $20,000, revenue is $100,000, and capital employed is $150,000. Calculate the profit margin and ROCE.
Current assets are $30,000 (including inventory of $10,000), and current liabilities are $15,000. Calculate the current ratio and the acid-test ratio.
Explain the difference between the current ratio and the acid-test ratio.
Cost of sales is $60,000 and average inventory is $8,000. Calculate the inventory turnover in times and in days.
Trade receivables are $12,000 and credit sales for the year are $100,000. Calculate the trade receivables turnover in days.
Trade payables are $9,000 and credit purchases for the year are $62,000. Calculate the trade payables turnover in days.
Explain why cash and profit are not the same thing.
State two factors that make it difficult to compare the ratios of two different businesses.
Suggest one way a business could improve its current ratio.
Worked solutions
Show worked solutions
Accounting Ratios and Interpretation — Practice: Solutions
Revenue $100,000, COS $60,000. GP margin, mark-up.
Profit $20,000, revenue $100,000, capital employed $150,000.
CA $30,000 (inv $10,000), CL $15,000.
Current ratio vs acid-test ratio.
COS $60,000, average inventory $8,000.
Receivables $12,000, credit sales $100,000.
Payables $9,000, credit purchases $62,000.
Why are cash and profit different?
Two factors making inter-business comparison difficult.
How to improve the current ratio.
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