Calculation and evaluation of ratios — common mistakes

In examination questions, never just state a calculated ratio. You must interpret it. For example, state that the gross profit margin has 'deteriorated from 25% to 20%', then provide a possible reason, such as 'due to an increase in the cost of raw materials'.

When analysing ROCE, compare it to the interest rates on loans. If ROCE is higher than the interest rate on borrowed funds, the business is creating value for its shareholders. If it is lower, the debt is not being used effectively.

Always link liquidity to working capital management. A poor liquidity ratio can often be explained by issues with efficiency ratios, such as slow inventory turnover or long trade receivables collection periods.

For evaluation, you must connect the ratios. For example, 'The company's liquidity has worsened, as shown by the fall in the current ratio. This is likely caused by the increase in the trade receivables turnover period from 30 to 55 days, which has tied up cash in outstanding customer debts.'

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.

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).

'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.