Interpretation of Accounting Ratios

Calculating a ratio scores 1–2 marks. Interpreting it well can score 3–5 marks and is where the real discrimination between grades occurs on Cambridge 0452 papers.

Every interpretation answer needs three components:

1. State the direction and magnitude "The current ratio has increased from 1.8:1 to 2.4:1."

2. State whether this is an improvement or deterioration (and relative to a benchmark) "This represents an improvement and is within the acceptable range of 1.5:1 to 2:1."

3. Explain the likely cause (this is the key mark-earner) "This may have been caused by an increase in inventory held or a reduction in trade payables as the business paid suppliers more quickly."

What counts as a meaningful comparison?

• Time series (year-on-year): is the ratio improving or deteriorating over time?
• Cross-sectional (industry/competitor): is the business above or below the industry average?
• Budget/target: is the business meeting its planned performance?

Without a comparison point, a ratio figure alone does not tell you whether performance is good or bad. A gross profit margin of 30% could be excellent in one industry and terrible in another.

Gross Profit Margin (GPM)

A fall in GPM means less of each sale is retained after cost of sales. Possible causes:

• Selling price reduced (deliberate discounting to attract customers, or competitive pressure)
• Cost of purchases increased (supplier price rises, higher raw material costs) without a corresponding increase in selling price
• Product mix shifted to lower-margin items (e.g., selling more of a cheap product and less of a premium one)
• Inventory theft or wastage recorded as cost of sales increases the cost without equivalent revenue

An increase in GPM suggests higher selling prices, lower purchase costs, or a shift to higher-margin products.

Profit Margin (Net Profit Margin)

A fall in profit margin when GPM is stable means expenses have increased disproportionately:

• Higher wages or salaries
• Increased rent (new premises)
• Higher depreciation charge (new assets purchased)
• One-off exceptional expenses (legal costs, bad debt write-offs)

If both GPM and profit margin fall, the problem starts at the trading level (cost of sales issue). If only profit margin falls, look at operating expenses.

Return on Capital Employed (ROCE)

ROCE can fall for two distinct reasons — and identifying which applies is the key to a full-mark answer:

1. Net profit has fallen (while capital employed stays the same) → profitability problem
2. Capital employed has increased (while profit stays the same or grows more slowly) → the business has invested heavily in new assets or taken on new long-term loans; these investments have not yet generated proportionally higher profits

A rising ROCE suggests either profit has improved, or the business is generating more profit per dollar of capital — a sign of improved efficiency.

Current Ratio

The current ratio measures whether current assets are sufficient to cover current liabilities.

Causes of a falling current ratio:

• Current liabilities have increased faster than current assets (e.g., more credit purchases, overdraft increased)
• Current assets have fallen (e.g., inventory run down, trade receivables collected and spent)

Causes of a rising current ratio:

• More inventory purchased and held (but this does NOT improve the liquid ratio)
• Trade receivables have increased (customers owing more)
• Cash or bank balance has grown

Liquid (Acid Test) Ratio

The liquid ratio excludes inventory and is a more stringent test. A ratio below 1:1 means the business cannot pay its current debts from liquid assets alone — it would need to sell inventory first.

• If the current ratio is adequate (e.g., 2:1) but the liquid ratio is low (e.g., 0.6:1), the business has a large proportion of its current assets tied up in inventory, which may not be quickly convertible to cash.
• This is especially concerning for businesses that sell slow-moving goods.

Trade Receivables Collection Period

• Longer (more days): customers are taking longer to pay. This could indicate:
  • Poor credit control (the business is not chasing debts effectively)
  • The business has extended credit terms to attract more customers (deliberate policy)
  • Some debts may be irrecoverable — risk of bad debt losses
• Shorter (fewer days): customers are paying faster — good for cash flow; may indicate stricter credit control or cash sales policies.

Trade Payables Payment Period

• Longer (more days): the business is taking longer to pay its suppliers. This could indicate:
  • Cash flow problems — the business cannot afford to pay on time
  • The business has negotiated extended credit terms (could be positive)
  • Risk of damaging supplier relationships or losing trade discounts
• Shorter (fewer days): paying suppliers more quickly — could be taking advantage of early payment discounts; reduces risk of supplier problems.

Inventory Turnover

• Higher turnover (fewer days): inventory is selling quickly. Positive signals: fast-moving products, efficient purchasing, avoiding obsolescence. Expected in supermarkets/food retailers where inventory must turn over quickly.
• Lower turnover (more days): inventory is sitting on shelves longer. Negative signals: slow-moving goods, overstocking, risk of inventory becoming obsolete or damaged. May tie up working capital.

The Working Capital Cycle: ideally, trade receivables days should be shorter than trade payables days — the business collects cash from customers before it must pay suppliers. If receivables days exceed payables days, the business may face a cash flow gap.