Ratio analysis

Why ratios matter in FR

Section C of the FR exam normally includes an interpretation question. You are given financial statements and some background, and asked to analyse performance and position. Ratios are the starting point, not the answer.

The main ratios

Profitability

• Gross profit margin = gross profit ÷ revenue × 100
• Operating profit margin = profit from operations ÷ revenue × 100
• Return on capital employed (ROCE) = profit from operations ÷ (equity + non-current liabilities) × 100

Liquidity

• Current ratio = current assets ÷ current liabilities
• Quick ratio = (current assets − inventory) ÷ current liabilities

Efficiency

• Inventory days = inventory ÷ cost of sales × 365
• Receivables days = trade receivables ÷ revenue × 365
• Payables days = trade payables ÷ cost of sales × 365
• Asset turnover = revenue ÷ capital employed

Gearing

• Gearing = debt ÷ equity, or debt ÷ (debt + equity)
• Interest cover = profit from operations ÷ finance costs

Turning ratios into marks

For each important movement:

1. State it: "Gross margin fell from 32% to 27%."
2. Explain the likely cause from the scenario: "This is consistent with the price cuts made to win the new contract."
3. Say what it means: "Revenue grew, but each sale is now less profitable."

Use the information in the question, such as a new contract, an acquisition, a revaluation or a change in credit terms. Generic comments without the scenario score poorly.

Common mistakes

• Spending too long on calculations and leaving little time for analysis.
• Describing changes without explaining them.
• Ignoring one-off items that distort the comparison.

Where this leads

Interpretation skills are used again in ACCA SBR, where you analyse financial statements from an investor's point of view.