Calculating and Understanding Accounting Ratios

A business's income statement might show a gross profit of $200,000. But does that tell you whether the business is performing well? Without context it is meaningless. Is revenue $400,000 or $4,000,000? Has gross profit grown or shrunk compared to last year? Is the margin better or worse than a competitor's?

Accounting ratios solve this problem by expressing financial relationships as a percentage, a ratio, or a rate. They allow us to:

1. Compare over time — is the business improving or declining?
2. Compare with similar businesses — is the business outperforming or underperforming competitors?
3. Identify problems — a falling current ratio might signal a liquidity crisis before it becomes a cash crisis.

The Cambridge 0452 syllabus divides ratios into three groups:

• Profitability — how much profit is the business making relative to sales and capital?
• Liquidity — can the business pay its short-term debts?
• Efficiency — how effectively is the business managing receivables, payables, and inventory?

Critical rule on presentation:

• Profitability ratios → expressed as % (e.g., 35%)
• Liquidity ratios → expressed as a ratio (e.g., 2.1:1) — not as a percentage
• Efficiency ratios → expressed in days (e.g., 42 days) or times per year (e.g., 8 times)

Getting the presentation wrong is one of the most common mark losses in the Cambridge 0452 exam, so always check which unit applies before writing your final answer.

1. Gross Profit Margin (GPM)

$\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100$

• What it measures: the percentage of each dollar of revenue that remains after deducting the direct cost of sales (cost of goods sold). It shows how much margin the business earns before paying operating expenses.
• Source of figures: gross profit and revenue both come from the income statement (trading account section).

Example: Revenue = $500,000; Gross Profit = $175,000 $\text{GPM} = \frac{175{,}000}{500{,}000} \times 100 = 35\%$

2. Profit Margin (Net Profit Margin)

$\text{Profit Margin} = \frac{\text{Net Profit}}{\text{Revenue}} \times 100$

• What it measures: the percentage of each dollar of revenue remaining after ALL expenses (operating expenses such as wages, rent, depreciation) have been deducted as well as cost of sales. It is the "bottom line" profitability measure relative to sales.
• Note: Cambridge 0452 uses the term profit margin or net profit margin; both are acceptable.

Example: Net Profit = $62,500; Revenue = $500,000 $\text{Profit Margin} = \frac{62{,}500}{500{,}000} \times 100 = 12.5\%$

3. Return on Capital Employed (ROCE)

$\text{ROCE} = \frac{\text{Net Profit}}{\text{Capital Employed}} \times 100$

Where: $\text{Capital Employed} = \text{Total Equity} + \text{Non-current Liabilities}$ $= \text{Total Assets} - \text{Current Liabilities}$

• What it measures: how much profit is generated for every $100 of long-term capital invested in the business. It is the most important measure of overall business efficiency because it judges profit against all funds tied up in the business, not just sales.
• Capital employed source: from the statement of financial position — add the owner's equity (capital) to any long-term (non-current) loans. Alternatively: total assets minus current liabilities.

Example: Net Profit = $62,500; Total Equity = $380,000; Long-term Loan = $120,000 $\text{Capital Employed} = 380{,}000 + 120{,}000 = 500{,}000$ $\text{ROCE} = \frac{62{,}500}{500{,}000} \times 100 = 12.5\%$

Liquidity means the ability to meet short-term obligations using available assets. The two liquidity ratios compare current assets with current liabilities.

1. Current Ratio

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \text{ expressed as } X:1$

• What it measures: for every $1 of current liabilities, how many dollars of current assets are available? A ratio of 2:1 means there are $2 of current assets for every $1 owed.
• Acceptable range: typically 1.5:1 to 2:1. Below 1:1 the business may struggle to pay its debts; very high ratios (e.g., 4:1) may indicate inefficient use of cash or excess inventory.

Example: Current Assets = $84,000; Current Liabilities = $42,000 $\text{Current Ratio} = \frac{84{,}000}{42{,}000} = 2:1$

2. Liquid (Acid Test) Ratio

$\text{Liquid Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \text{ expressed as } X:1$

• Why exclude inventory? Inventory is the least liquid current asset — it cannot always be quickly converted to cash (it must first be sold, possibly on credit). The acid test therefore gives a more stringent test of immediate liquidity.
• Acceptable range: approximately 1:1. Below 0.5:1 is cause for serious concern.

Example: Current Assets = $84,000; Inventory = $36,000; Current Liabilities = $42,000 $\text{Liquid Ratio} = \frac{84{,}000 - 36{,}000}{42{,}000} = \frac{48{,}000}{42{,}000} = 1.14:1$

Important: both ratios must be expressed as X:1 (e.g., 2:1, 1.14:1), never as a percentage.

Efficiency ratios (sometimes called activity ratios) measure how well a business manages the assets and liabilities that flow through its normal trading cycle.

1. Trade Receivables Collection Period

$\text{Trade Receivables Days} = \frac{\text{Trade Receivables}}{\text{Revenue}} \times 365 \text{ days}$

• What it measures: the average number of days it takes for the business to collect payment from credit customers. A lower number is generally better (cash is collected faster).

Example: Trade Receivables = $45,625; Revenue = $500,000 $\text{Collection Period} = \frac{45{,}625}{500{,}000} \times 365 = 33 \text{ days}$

2. Trade Payables Payment Period

$\text{Trade Payables Days} = \frac{\text{Trade Payables}}{\text{Cost of Sales}} \times 365 \text{ days}$

• What it measures: the average number of days the business takes to pay its suppliers. A higher number means the business keeps cash for longer, but excessively long periods may damage supplier relationships.
• Note: the denominator is cost of sales, not revenue — suppliers are paid for goods purchased, not goods sold.

Example: Trade Payables = $26,250; Cost of Sales = $325,000 $\text{Payment Period} = \frac{26{,}250}{325{,}000} \times 365 = 29.5 \approx 30 \text{ days}$

3. Rate of Inventory Turnover

In times per year: $\text{Inventory Turnover} = \frac{\text{Cost of Sales}}{\text{Average Inventory}} \text{ times}$

In days: $\text{Inventory Days} = \frac{\text{Average Inventory}}{\text{Cost of Sales}} \times 365 \text{ days}$

Where: $\text{Average Inventory} = \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2}$

• What it measures: how many times per year (or how many days on average) inventory is replaced/sold. A higher turnover rate (fewer days) means inventory moves quickly — generally desirable.

Example: Opening Inventory = $28,000; Closing Inventory = $36,000; Cost of Sales = $325,000 $\text{Average Inventory} = \frac{28{,}000 + 36{,}000}{2} = 32{,}000$ $\text{Inventory Turnover} = \frac{325{,}000}{32{,}000} = 10.2 \text{ times}$ $\text{Inventory Days} = \frac{32{,}000}{325{,}000} \times 365 = 35.9 \approx 36 \text{ days}$