Revise Calculation and evaluation of ratios for Cambridge 9706 (1.6.2)

Ratio analysis is the process of evaluating a business's financial performance and position by comparing items from its financial statements. It is a vital tool for stakeholders-such as investors, managers, and lenders-to make informed decisions. Ratios standardise financial information, allowing for meaningful comparisons over time (trend analysis), against budgeted figures, and with other businesses in the same industry (inter-firm comparison). However, ratios are not an end in themselves; they are indicators that highlight areas requiring further investigation. The four key categories you must master for your examination are profitability, liquidity, efficiency, and gearing. A strong analysis moves beyond mere calculation to interpret what the numbers mean in the context of the business and its economic environment.

While powerful, ratio analysis has significant limitations. Ratios are calculated using historical data from financial statements, which may not reflect the current or future position of the business. Different accounting policies (e.g., on depreciation or inventory valuation) can distort comparisons between firms. Furthermore, financial statements can be subject to 'window dressing'-actions taken just before the year-end to make the accounts look more favourable. Ratios also ignore qualitative factors such as employee morale, customer loyalty, and the quality of management, which are crucial for long-term success. Therefore, ratios should be used as a starting point for further inquiry, not as the sole basis for a conclusion.

Profitability ratios measure a company's ability to generate profit from its sales and capital. The Gross Profit Margin ((Gross Profit / Revenue) x 100) reveals how efficiently a business is managing its direct costs of production or purchase. A higher margin is preferable. The Profit Margin ((Profit for the Year / Revenue) x 100) shows the overall profitability after all expenses, including overheads, are deducted. The most comprehensive profitability ratio is the Return on Capital Employed (ROCE), calculated as (Profit from Operations / Capital Employed) x 100. ROCE assesses how effectively the business uses its long-term financing to generate profit, making it a key indicator for investors.

Liquidity refers to the ability of a business to meet its short-term financial obligations as they fall due. The Current Ratio (Current Assets / Current Liabilities) compares all assets expected to be converted to cash within a year against liabilities due within a year. A commonly cited ideal is between 1.5:1 and 2:1. The Acid Test Ratio, or Quick Ratio, ((Current Assets - Inventory) / Current Liabilities) provides a more stringent measure by excluding inventory, which is often the least liquid current asset. An ideal Acid Test Ratio is typically around 1:1. A ratio below 1:1 suggests potential cash flow problems, as the business may be unable to pay its immediate debts without selling inventory.

Efficiency ratios, also known as activity or turnover ratios, measure how effectively a business is using its assets to generate revenue and manage its working capital. They provide insight into the operational performance of the business. Poor efficiency can directly impact liquidity and profitability. For example, if a business takes too long to sell its inventory or collect payments from customers, cash becomes tied up in working capital, potentially leading to a cash shortage. Key efficiency ratios include inventory turnover, trade receivables turnover, and trade payables turnover.

The gearing ratio measures the extent to which a company's capital is financed by long-term debt. It is a crucial indicator of a company's long-term financial stability and risk profile. The formula is (Non-Current Liabilities / Capital Employed) × 100, where Capital Employed is Total Equity + Non-Current Liabilities. A company with a gearing ratio above 50% is often considered 'highly geared', meaning it relies more on debt than on equity to finance its operations. High gearing increases financial risk because the company has a legal obligation to make interest payments on its debt, regardless of its profitability. In a downturn, these fixed payments can strain cash flow and even lead to insolvency. However, gearing can also be beneficial. If the return generated by the business (ROCE) is greater than the interest rate paid on debt, the excess return magnifies the profits available to shareholders. This is known as financial leverage.

GP margin = $\frac{\text{Gross profit}}{\text{Revenue}} \times 100$

Profit margin = $\frac{\text{Profit for the year}}{\text{Revenue}} \times 100$

ROCE = $\frac{\text{PBIT}}{\text{Capital employed}} \times 100$

Current ratio = $\frac{\text{Current assets}}{\text{Current liabilities}}$

Acid test = $\frac{\text{Current assets - Inventory}}{\text{Current liabilities}}$

Inventory turnover (days) = $\frac{\text{Average inventory}}{\text{Cost of sales}} \times 365$

Trade receivables turnover (days) = $\frac{\text{Trade receivables}}{\text{Credit revenue}} \times 365$

Gearing = $\frac{\text{Non-current liabilities}}{\text{Capital employed}} \times 100$