Evaluation of ratios

Possible reasons (any two/three): the business has raised its selling prices; it has reduced its purchase (cost of sales) prices (e.g. negotiating with suppliers); or it has changed its sales mix toward higher-margin products.

Comparing with previous years shows the trend in performance — whether each ratio is improving or deteriorating over time. A single year's figure has no context, but a trend reveals the direction of the business's profitability, liquidity and efficiency, helping users judge performance and spot problems early.

Because the gross profit margin is unchanged, the fall in the profit margin must be due to rising expenses relative to sales (the expenses-to-revenue ratio has increased) — not a buying/selling problem.

The fall in the acid test ratio shows that liquidity has weakened. This can be connected if, for example, the higher expenses have used up cash, or if the business has been holding more inventory / collecting receivables more slowly, tying up cash and reducing its quick assets.

So the changes may share a common cause — cash being tied up or consumed — linking the profitability (expense) problem to the liquidity (acid test) problem. The directors should investigate both the rising expenses and the working-capital position together.

Low ROCE → increase profit from operations or reduce capital employed. For example, selling off underused non-current assets lowers capital employed and raises ROCE. Drawback: it may reduce capacity for future growth.

Weak acid test → improve cash flow. For example, collecting receivables faster (tighter credit control / settlement discounts) and reducing inventory brings in and frees cash, raising the acid test. Drawback: tight credit terms may lose customers, and cutting inventory too far risks stock-outs.

Each measure targets the specific weakness, but the business must weigh the trade-offs rather than maximising one ratio at the expense of sales or growth.

Ratio analysis is useful, but it has important limitations, especially when comparing two businesses:

• Different accounting policies. The two businesses may use different depreciation methods, inventory valuations or revaluation policies, so their figures are not on the same basis and the ratios are not directly comparable.
• Different size and industry. Comparing businesses of different sizes or in different industries is unreliable, because 'normal' ratios differ between sectors (e.g. a supermarket vs a manufacturer).
• Historic figures. Ratios are based on past statements, so they may not reflect current or future performance.
• Qualitative factors ignored. Ratios ignore management quality, staff, brand, market conditions and the economy, which strongly affect performance.
• Single date / window dressing. The statement of financial position reflects one date, which may be untypical, and figures can be window-dressed near the year end to flatter the ratios.

Conclusion. Ratios are a valuable but incomplete tool. To compare two businesses fairly, the user must allow for policy and size differences, look at trends over several years, and consider qualitative and external factors alongside the ratios — so conclusions from ratios alone should be treated with caution.

Profitability — improving. The rising profit margin and ROCE show the company is making more profit per $ of sales and earning a better return on its capital — a positive sign that suggests good control of costs and use of resources.

Liquidity — deteriorating. However, the falling current and acid test ratios and the rising overdraft show that liquidity is worsening — the company is finding it harder to pay its short-term debts and is relying more on its overdraft. This could indicate overtrading (growing faster than its working capital) or cash being tied up in inventory and receivables.

Advice to the directors.

• Address the liquidity weakness urgently: tighten credit control, manage inventory down, and ensure suppliers are paid within (not before) terms.
• Raise long-term finance (a loan or share capital) to fund the higher level of trading, rather than relying on the overdraft.
• Continue the good profitability work, but not at the expense of cash.

Conclusion. Overall performance is mixed: profitability is improving, but the deteriorating liquidity is a serious risk — a profitable business can still fail for lack of cash, so the directors should prioritise restoring liquidity. (This conclusion is based on historic ratios and should be reviewed alongside trends and other information.)

Return on capital employed depends on both the profit margin and how much revenue the business generates from its capital (its asset turnover), not on the margin alone.

A business with a lower profit margin can still have a higher ROCE if it has a much higher asset turnover — that is, it generates far more sales from its capital. Even though it earns a small profit on each sale, the large volume of sales produces a high total operating profit relative to its capital, giving a high ROCE. A common example is a supermarket, which works on low margins but very high sales volumes from its assets.

By contrast, a competitor with a high margin but low asset turnover (e.g. a capital-heavy business making few but high-value sales) may have a lower ROCE. So ROCE must be interpreted together with asset turnover, and a higher margin does not guarantee a higher return on capital.

Window dressing is the practice of arranging transactions around the year end to make the financial statements (and ratios) appear more favourable than the true ongoing position. For example, a business might delay making purchases or push to collect receivables just before the year end to boost its cash and improve its current and acid test ratios.

This limits the usefulness of liquidity ratios because they are measured at a single date (the year end). A ratio that looks healthy on that date may not represent the business's typical liquidity during the year, so users could be misled into thinking it is more liquid than it really is.

Any two of: the quality and experience of management; the skill and motivation of employees; the strength of the brand/reputation; market conditions, competition and the state of the economy.

Likely cause. ROCE = profit from operations ÷ capital employed. Since the profit margin is broadly unchanged, the fall in ROCE is unlikely to be caused by a drop in operating profit per sale. The more likely cause is a rise in capital employed — for example new non-current assets that have not yet started generating sales/profit, or a build-up of working capital — which has diluted the return on the (now larger) capital base. (A fall in sales volume/asset turnover would have the same effect.)

How to restore ROCE. ROCE rises if profit from operations increases or capital employed falls:

• Increase profit from operations — raise revenue from the existing capital (e.g. use the new assets fully to lift sales) or control costs. Reason: a higher numerator on the same capital raises ROCE.
• Reduce capital employed — sell or write off underused non-current assets and reduce excess inventory/idle cash. Reason: a lower denominator raises ROCE.

Conclusion. The fall is most likely due to capital employed rising faster than profit (e.g. recent investment not yet earning). The directors should make the additional capital productive (raise sales/profit) and trim any underused capital, so that the return on capital is restored — while recognising that a recent investment may take time to deliver returns. (This conclusion is based on historic ratios and should be reviewed with trends and other information.)