Ratio analysis and interpretation - Profitability, efficienc...

Learning Outcomes

After reading this article, you will be able to calculate and interpret the main financial ratios used in assessing company performance and financial position. You will be able to explain the meaning of profitability, efficiency, liquidity, and gearing ratios, discuss their use and limitations, and apply your knowledge to exam-style analysis and decision-making scenarios.

ACCA Financial Reporting (FR) Syllabus

For ACCA Financial Reporting (FR), you are required to understand and apply accounting ratios to analyse and interpret the performance and financial position of entities. In particular, this article covers:

• The calculation and interpretation of key financial ratios for profitability, efficiency, liquidity, and gearing.
• Explanation of what specific ratios are intended to assess.
• Comparison of ratios between different periods and against industry norms.
• Application of ratio analysis to stakeholder needs and decision-making.
• Evaluation of the limitations of ratio analysis when interpreting financial statements.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which ratio measures how effectively a company turns its sales into profits before deducting finance costs or tax?
   1. Net asset turnover
   2. Gross profit margin
   3. Operating profit margin
   4. Gearing
2. What information does the quick ratio provide that the current ratio does not?
   1. Profitability excluding inventory
   2. Liquidity excluding the value of inventory
   3. Efficiency of capital employed
   4. Interest cover
3. A company has total debt of $300,000 and equity of $600,000. What is its debt to equity gearing ratio?
   1. 25%
   2. 33%
   3. 50%
   4. 100%

4. True or false? An increase in average receivables days could suggest weaker credit control by a company.

Introduction

Ratio analysis is a core technique in interpreting a company's financial statements. Ratios condense large sets of financial data into clear measures to assist users—such as investors, lenders, and management—in making comparisons, evaluating performance, and identifying trends. Common ratio categories include profitability, efficiency, liquidity, and gearing. Each group of ratios highlights different aspects of business health and risk.

However, ratios must be used with care. Their value depends on accurate computation, an understanding of their purpose and limitations, and the context in which they are analysed.

Profitability Ratios

Profitability ratios measure the ability of a company to generate profits from its revenue and capital.

Key Term: gross profit margin
The percentage of sales revenue remaining after deducting cost of sales, showing the margin earned on goods or services sold.

Key Term: operating profit margin
The percentage of sales revenue left after deducting operating costs, showing the profit from core business activities before interest and tax.

Key Term: return on capital employed (ROCE)
Operating profit as a percentage of capital employed (equity plus interest-bearing debt), indicating how efficiently long-term funds are used to generate profit.

The main profitability ratios to be aware of for the exam are:

• Gross profit margin:
  $\text{Gross profit margin (\%)} = \frac{\text{Gross profit}}{\text{Revenue}} \times 100$
• Operating profit margin:
  $\text{Operating profit margin (\%)} = \frac{\text{Operating profit}}{\text{Revenue}} \times 100$
• ROCE:
  $\text{ROCE (\%)} = \frac{\text{Operating profit}}{\text{Capital employed}} \times 100$

A high gross profit margin suggests strong pricing power or efficient production. A low, or declining, operating profit margin may indicate costs have increased or pricing strategies have weakened.

Worked Example 1.1

Mira Ltd reports revenue of $2,000,000, cost of sales of $1,400,000, and operating expenses of $300,000. Capital employed is $1,200,000. Calculate the gross profit margin, operating profit margin, and ROCE.

Answer:

• Gross profit = $2,000,000 - $1,400,000 = $600,000
• Gross profit margin = ($600,000 / $2,000,000) × 100 = 30%
• Operating profit = $600,000 - $300,000 = $300,000
• Operating profit margin = ($300,000 / $2,000,000) × 100 = 15%
• ROCE = ($300,000 / $1,200,000) × 100 = 25%

Efficiency (Activity) Ratios

Efficiency ratios assess how effectively a company uses its assets and manages its operations.

Key Term: net asset turnover
The ratio of revenue to capital employed, measuring how efficiently assets generate sales.

Key Term: inventory turnover period
The number of days inventory is held before sale, showing inventory management efficiency.

Key Term: receivables collection period
The average number of days taken to collect cash from credit customers.

Key Term: payables payment period
The average number of days a company takes to pay its suppliers.

Key efficiency ratios include:

• Net asset turnover:
  $\text{Net asset turnover} = \frac{\text{Revenue}}{\text{Capital employed}}$
• Inventory turnover (days):
  $\frac{\text{Inventory}}{\text{Cost of sales}} \times 365$
• Receivables collection period (days):
  $\frac{\text{Trade receivables}}{\text{Revenue}} \times 365$
• Payables payment period (days):
  $\frac{\text{Trade payables}}{\text{Cost of sales}} \times 365$

A lower inventory period or receivables period often reflects good management but may also indicate stockouts or rigid credit terms.

Worked Example 1.2

Parker Co reports: Inventory $150,000, revenue $900,000, cost of sales $600,000, receivables $100,000, payables $80,000. Calculate inventory turnover, receivables, and payables days.

Answer:

• Inventory turnover = (150,000 / 600,000) × 365 = 91 days
• Receivables days = (100,000 / 900,000) × 365 ≈ 40 days
• Payables days = (80,000 / 600,000) × 365 ≈ 49 days

Liquidity Ratios

Liquidity ratios assess a company's ability to meet its short-term obligations as they fall due.

Key Term: current ratio
The ratio of current assets to current liabilities, measuring coverage of liabilities by liquid assets.

Key Term: quick ratio
The ratio of current assets (excluding inventory) to current liabilities. Also called the "acid test," it assesses short-term liquidity without relying on inventory.

Main liquidity ratios:

• Current ratio:
  $\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}$
• Quick ratio:
  $\text{Quick ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$

A current ratio significantly less than 1:1 suggests possible cash flow problems; a ratio much higher than the industry norm may tie up too many resources in working capital.

Gearing Ratios (Financial Gearing)

Gearing ratios identify the degree of financial risk by measuring the level of borrowings compared to equity funding.

Key Term: gearing
The proportion of a company’s capital provided by debt, as opposed to equity.

Key Term: interest cover
The number of times operating profit exceeds finance costs, measuring ability to pay interest.

Common gearing ratios:

• Debt to equity ratio:
  $\text{Gearing (\%)} = \frac{\text{Debt}}{\text{Equity}} \times 100$
• Debt to total capital employed:
  $\text{Gearing (\%)} = \frac{\text{Debt}}{\text{Equity} + \text{Debt}} \times 100$
• Interest cover:
  $\text{Interest cover} = \frac{\text{Operating profit}}{\text{Finance costs}}$

Higher gearing increases risk—especially if profits decline or interest rates rise—while also offering potential for higher returns on equity.

Worked Example 1.3

Delta Ltd has long-term debt of $500,000, equity of $1,000,000, operating profit of $120,000 and finance costs of $24,000. What is its gearing and interest cover?

Answer:

• Gearing = ($500,000 / $1,000,000) × 100 = 50% (debt/equity)
• Interest cover = $120,000 / $24,000 = 5 times

Using and Interpreting Ratios

Always compare ratios to prior years, similar entities, and industry benchmarks. Ratios on their own do not provide a full picture. Consider trends, context, and root causes of changes.

Exam Warning

It is common in the exam to be asked about the LIMITATIONS of ratio analysis. Remember, figures in financial statements may not reflect their true value due to historical cost accounting, differing policies, or seasonal fluctuations. Avoid drawing strong conclusions from ratios alone.

Limitations of Ratio Analysis

• Ratios reflect past performance—they are not predictive.
• Results can be distorted by changes in accounting policies or estimates.
• Year-end balances may not represent averages due to seasonality.
• Non-financial information (market share, customer satisfaction) is ignored.
• Window dressing and creative accounting may make the true position less clear.
• Inter-firm comparisons are valid only if accounting policies and business models are similar.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the main categories of financial ratios: profitability, efficiency, liquidity, and gearing.
• Calculate and interpret gross and operating profit margins, and return on capital employed (ROCE).
• Calculate and use efficiency ratios, including inventory, receivables, and payables periods, and net asset turnover.
• Assess short-term solvency using current and quick ratios.
• Evaluate long-term risk using gearing ratios and interest cover.
• Discuss the limitations of ratio analysis and the need to use ratios in context, considering comparability, seasonality, and non-financial factors.
• Compare ratio results over time, with similar businesses and sector averages.

Key Terms and Concepts

• gross profit margin
• operating profit margin
• return on capital employed (ROCE)
• net asset turnover
• inventory turnover period
• receivables collection period
• payables payment period
• current ratio
• quick ratio
• gearing
• interest cover