Summary
Accounting ratios are essential tools for evaluating a company's financial performance, helping stakeholders make informed decisions. They provide insights into profitability, liquidity, and efficiency.
- Gross Margin — the percentage of revenue remaining after covering the cost of goods sold. Example: If Gross Profit is 100,000, Gross Margin = 40%.
- Profit Margin — the percentage of sales revenue that remains as profit after all expenses. Example: With Sales of £50,000, Gross Profit of £20,000, and Expenses of £12,000, Profit Margin = 16%.
- Return on Capital Employed (ROCE) — measures how efficiently a business uses its capital to generate profits. Example: With Operating Profit of £15,000 and Capital Employed of £75,000, ROCE = 20%.
- Current Ratio — compares current assets to current liabilities to assess short-term financial stability. Example: With Current Assets of £60,000 and Current Liabilities of £40,000, Current Ratio = 1.5:1.
- Liquid (Acid Test) Ratio — measures the ability to meet short-term obligations without relying on inventory. Example: With Liquid Assets of £35,000 and Current Liabilities of £40,000, Liquid Ratio = 0.875:1.
- Rate of Inventory Turnover — indicates how quickly inventory is sold and replaced. Example: With Cost of Sales of £240,000 and Average Inventory of £40,000, Inventory Turnover = 6 times.
- Trade Receivables Turnover (Days) — shows the average number of days to collect payment from customers. Example: With Trade Receivables of 500,000, Receivables Turnover = 36.5 days.
- Trade Payables Turnover (Days) — indicates the average number of days to pay suppliers. Example: With Trade Payables of £30,000 and Credit Purchases of £180,000, Payables Turnover = 60.8 days.
Exam Tips
Key Definitions to Remember
- Gross Margin: Percentage of revenue remaining after cost of goods sold.
- Profit Margin: Percentage of sales revenue remaining as profit after expenses.
- ROCE: Efficiency of capital use to generate profits.
- Current Ratio: Current assets divided by current liabilities.
- Liquid Ratio: Liquid assets divided by current liabilities.
- Inventory Turnover: Cost of sales divided by average inventory.
- Receivables Turnover: Average days to collect payment from customers.
- Payables Turnover: Average days to pay suppliers.
Common Confusions
- Confusing gross margin with profit margin.
- Misinterpreting liquidity ratios as profitability measures.
Typical Exam Questions
- How do you calculate gross margin? Gross Margin = (Gross Profit ÷ Sales) × 100
- What does a current ratio of 1.5:1 indicate? It indicates the business has £1.50 of current assets for every £1 of current liabilities.
- How is ROCE calculated? ROCE = (Operating Profit ÷ Capital Employed) × 100
What Examiners Usually Test
- Ability to calculate and interpret different accounting ratios.
- Understanding the implications of ratios on business performance.
- Comparing ratios across different companies or time periods.