In simple terms
A friendly intro before the formal notes — no formulas yet.
Think of it like a doctor's check-up for a business. The ratios are the test results (like blood pressure or temperature). Your job is to interpret these results, see how they connect, and recommend a course of action to keep the business healthy.
What this topic covers
The official Cambridge syllabus points this lesson works through.
- 3.5.1.1
How to calculate the following ratios: – working capital cycle (in days) – net working assets to revenue (sales) – interest cover – gearing ratio – earnings per share – price/earnings ratio – dividend per share – dividend yield – dividend cover Note: Candidates must use the formula given in the appendix to section 3. These are the only formulae accepted in candidate responses.
- 3.5.1.2
How to analyse and evaluate the results of the ratios and draw conclusions
- 3.5.1.3
How to make appropriate recommendations to stakeholders on the basis of the analysis undertaken
- 3.5.1.4
The interrelationships between ratios
Explore the concept
Use the live diagram and synced steps — play it or tap a step card to walk through.
Full topic notes
Formal explanation with the rigour you need for the exam.
Key Financial Ratios for Paper 3
In your exam, you will be provided with an appendix containing the necessary formulae for ratio calculations. It is essential that you use only these formulae. However, simply knowing where to find them isn't enough. You must understand what each component means and what the final ratio tells you about the business. We will cover the key ratios grouped by what they measure: liquidity, gearing, profitability, and investment potential.
Liquidity and Working Capital Ratios
These ratios measure a company's ability to meet its short-term obligations. A key aspect of this is managing working capital - the funds used in day-to-day trading operations. Poor working capital management can lead to cash flow problems, even for a profitable company.
Gearing and Solvency Ratios
These ratios assess the long-term financial stability of a company, focusing on its level of debt. Gearing (or leverage) refers to the proportion of a company's capital that comes from debt. While debt can fuel growth, too much can be risky. Key ratios here are the gearing ratio and interest cover.
Profitability Ratios
While other profitability ratios like gross and profit margins are important, the A-Level syllabus for Paper 3 specifically highlights Earnings Per Share as a key metric from the shareholders' perspective. It shows the profit attributable to each ordinary share.
Investment and Shareholder Ratios
These ratios help current and potential investors evaluate the attractiveness of a company's shares as an investment. They combine accounting data with market information (the share price). Examples include the Price/Earnings (P/E) ratio, dividend yield, and dividend cover.
Analysing, Evaluating and Making Recommendations
Calculation is only the first step. The real skill lies in using the ratios to build a narrative about the company's performance and position. Your analysis must be contextual. A gearing ratio of 60% might be normal for a utility company but dangerously high for a tech start-up. Always consider the 'why' behind the numbers.
Comparison: Compare ratios against previous years (trend analysis) to identify improvement or deterioration. Compare against industry averages or key competitors to judge relative performance.
Context: Are there any one-off events affecting the figures (e.g., a major asset sale, a recession)? What is the general economic climate?
Interrelationships: Explain how ratios link together. For example, 'The company's decision to take on more debt (higher gearing) has increased its finance costs, which has reduced its interest cover and squeezed its profit margin.'
Stakeholder Perspective: Tailor your analysis. A lender cares most about gearing and interest cover. A shareholder is more focused on EPS, dividend yield, and the P/E ratio.
Conclusion and Recommendation: After analysing the data, you must come to a reasoned conclusion. Use command words like 'evaluate', 'advise', or 'recommend' as your cue to make a judgement and justify it.
In Paper 3, a question asking you to 'advise an investor' requires a balanced argument. You should present both positive and negative points revealed by your ratio analysis before reaching a final, justified recommendation. For example: 'Although the dividend yield is attractive, the low dividend cover and high gearing present significant risks. Therefore, a risk-averse investor should be cautious about investing in this company at present.'
Worked examples
See the formulas applied — reveal one step at a time, like the exam.
The directors of Z plc review the Statement of Cash Flows for the year. Net cash from operating activities was $420,000; investing outflows $180,000; dividends paid $95,000.
Explain why the Statement of Cash Flows is essential for assessing liquidity.
- 1
Profit per the SoPL can include non-cash items (depreciation, accruals). The SoCF shows actual cash generated ($420,000 from operations), whether the firm can fund investments ($180,000) and dividends ($95,000) without external borrowing, and highlights liquidity risk even when reported profit is higher.
Alpha plc's financial data for the year is as follows:
- Profit from operations: $500,000
- Finance costs: $100,000
- Total equity: $1,200,000
- Non-current liabilities: $800,000
Calculate Alpha plc's gearing ratio and interest cover, and briefly comment on the company's financial risk.
- 1
Step 1: Calculate the Gearing Ratio
How it all connects
The big idea sits in the middle — tap a linked idea to explore the link.
Tap a linked idea to see how it connects back to the main topic — that connection is what examiners reward.
Glossary
Try to recall each definition before you reveal it.
Quick check
Answer in your head first — then tap to check. No pressure.
Revision flashcards
Flip the card. Test yourself before the exam.
Gearing Ratio
Measures the proportion of a company's capital that comes from debt. A high ratio (e.g., >50%) indicates high financial risk.
Key takeaways
Review these before you close the topic — retrieval beats re-reading.
- ✓
Comparison: Compare ratios against previous years (trend analysis) to identify improvement or deterioration. Compare against industry averages or key competitors to judge relative performance.
- ✓
Context: Are there any one-off events affecting the figures (e.g., a major asset sale, a recession)? What is the general economic climate?
- ✓
Interrelationships: Explain how ratios link together. For example, 'The company's decision to take on more debt (higher gearing) has increased its finance costs, which has reduced its interest cover and squeezed its profit margin.'
- ✓
Stakeholder Perspective: Tailor your analysis. A lender cares most about gearing and interest cover. A shareholder is more focused on EPS, dividend yield, and the P/E ratio.
- ✓
Conclusion and Recommendation: After analysing the data, you must come to a reasoned conclusion. Use command words like 'evaluate', 'advise', or 'recommend' as your cue to make a judgement and justify it.
Practice — then mark it
The whole point: a real Cambridge question, marked mark-by-mark.
Practice Scenario
Practice Scenario
Frequently asked
Checkpoint
One marked question is worth ten re-reads — close the loop before you move on.
Reading it isn’t knowing it — prove it.
Before you move on: do Practice Scenario on paper, snap a photo, and get examiner-style feedback on exactly where you win and lose marks.