Question 1

Is a higher ratio always better?

Accepted Answer

Not necessarily. While a higher profitability ratio is generally positive, a very high Current Ratio could indicate poor asset management, such as holding too much idle cash or obsolete inventory. Similarly, an extremely high Inventory Turnover might mean the business is losing sales due to stock-outs. Context is crucial; ratios must be compared to industry averages and previous periods to be meaningful.

Question 2

Can I perform a full ratio analysis using only the Statement of Financial Position?

Accepted Answer

No, a comprehensive analysis requires data from both the Income Statement and the Statement of Financial Position. Profitability ratios like GPM are derived from the Income Statement. Liquidity and gearing ratios use the Statement of Financial Position. Crucially, key 'bridge' ratios like ROCE and all efficiency ratios require figures from both statements (e.g., profit from the Income Statement and capital employed from the Statement of Financial Position).

Question 3

What is the difference between 'profit for the year' and 'profit from operations' when calculating ROCE?

Accepted Answer

'Profit from operations' (operating profit) is profit before deducting interest and tax. This is the correct figure to use for ROCE because it measures profit generated from the company's core trading activities, independent of its financing and tax structure. This allows for a fairer comparison between companies with different debt levels. 'Profit for the year' is the final profit after all expenses, including interest and tax, have been deducted.

Calculation and evaluation of ratios

What you need to know

Calculation and evaluation of ratios