Analysis of Ratios

(a) Return on capital employed → profitability. (b) Current ratio → liquidity. (c) Trade receivables days → efficiency. (d) Interest cover → gearing/solvency.

A single ratio has no context — 1.4 : 1 is not inherently 'good' or 'bad'. To interpret it, it must be compared: with the company's previous years (has it risen or fallen?), with competitors or industry norms (is it typical for the sector?), and ideally with budget. For example, 1.4 : 1 would be reassuring if it had risen from 0.8 : 1 but worrying if it had fallen from 2.5 : 1. Without such a comparison, the figure cannot support a sound conclusion about liquidity.

A bank's main concern is whether the company can service and repay the loan, so it focuses on: gearing — to see how much debt the company already carries and whether more debt would make it dangerously highly geared; interest cover — to check that profit comfortably covers the interest, so the new interest could be paid even if profits dipped; and liquidity ratios (current and acid-test) — to confirm the company can meet its short-term obligations as well. The bank may also look at profitability/ROCE (to confirm the business is viable) and the trend in these ratios. It is less interested in investment ratios such as dividend yield, which matter to shareholders rather than lenders.

The rising ROCE and gross margin show that the company is trading profitably and using its capital efficiently — at first glance a strong performance.

However, the falling current ratio (0.8 : 1) and lengthening working capital cycle reveal a serious liquidity problem: the company holds less than $1 of current assets per $1 of current liabilities, and cash is being tied up for longer in inventory and receivables. This means it may struggle to pay its short-term debts as they fall due.

Read together, these ratios suggest possible overtrading — the company may be expanding its profitable trade faster than its working capital can support, so that despite healthy profits it is short of cash. This illustrates that profitability and liquidity must be analysed together: a profitable company can still face a cash crisis (profit is not cash). The company should improve working capital management (tighter credit control, lower inventory) and consider additional finance to support its growth.

Ratio analysis is useful but has several important limitations.

First, it is based on historical data — the financial statements report the past, which may not reflect the company's current or future position, especially in a fast-changing environment.

Secondly, it ignores non-financial factors that strongly affect performance — such as the quality of management, brand reputation and product quality, staff morale, and economic and competitive conditions — none of which appear in the ratios.

Thirdly, comparisons can be unreliable because companies use different accounting policies (e.g. depreciation methods, inventory valuation), so their ratios are not on the same basis; the statement of financial position is also only a snapshot at the year-end, which may be seasonal or window-dressed.

Finally, ratios show what has happened but not why, so they are a starting point for investigation rather than a complete answer.

For these reasons, ratios should be used as one input among several, alongside the narrative, non-financial information and judgement, and any conclusion should acknowledge these limitations.

Two companies may apply different accounting policies — for example, one might depreciate using the straight-line method and the other the reducing-balance method, or value inventory using FIFO rather than AVCO. These choices change the reported profit, asset values and inventory figures, so ratios such as ROCE, profit margins and the current ratio are calculated on different bases. Comparing them directly could therefore make one company look better or worse than it really is, leading to a misleading conclusion — the comparison is not like-for-like.

Ratios are based only on the financial statements and therefore omit many factors that strongly affect a company's future. An investor should also consider non-financial factors such as the quality and stability of management, the strength of the brand and product quality, customer loyalty, staff morale and industrial relations, and the economic, competitive and regulatory environment. These influence the company's future prospects and risks in ways the ratios cannot show. A company with strong ratios but weak management or a declining market may be a poor investment, while one with modest current ratios but excellent prospects may be a good one — so non-financial information is essential for a balanced decision.

The fallen net profit margin tells the directors what has happened — profitability has worsened — but not why. The cause could be rising costs (materials, wages, overheads), price cuts to win sales, a change in the product mix, one-off expenses, or falling sales volume. Each cause requires a different response. Ratio analysis therefore only flags the problem; the directors must investigate the underlying figures and operations to identify the cause before they can decide on the appropriate corrective action.

I would carry out the analysis in a structured way.

First, calculate and group the ratios — profitability (ROCE, margins), liquidity (current, acid-test), efficiency (inventory turnover, receivables/payables days), gearing/solvency (gearing, interest cover) and investment (EPS, dividend yield/cover, P/E).

Secondly, interpret each by comparison — against previous years (trend) and against competitors or industry norms — explaining the direction of change and the likely cause, not just the figure.

Thirdly, synthesise the groups into an overall picture, drawing out how they interrelate (e.g. is the company profitable but illiquid?) and focusing on what matters to the investor (returns, risk and prospects).

Fourthly, acknowledge the limitations of ratio analysis — historical data, non-financial factors, accounting-policy differences and the year-end snapshot — and recommend considering non-financial information too.

Finally, give a clear, balanced recommendation as to whether the investor should invest, justified by the evidence. This group → compare → synthesise → limitations → recommend structure produces a sound and well-supported conclusion.

The statement of financial position is a snapshot at a single date (the year-end). For a seasonal business, inventory, receivables or cash at the year-end may be unusually high or low compared with the rest of the year. The figures could also be window-dressed — deliberately improved at the year-end (e.g. by delaying purchases or collecting debts early). So the liquidity ratios may not reflect the position the business holds for most of the year.