prepare and comment on simple statements showing comparison of results for different years

6.2 Interpretation of Accounting Ratios

Learning Objectives

By the end of this section you will be able to:

• Prepare a simple statement that compares the financial results of a business for two (or more) years.
• Calculate the eight ratios required by the Cambridge IGCSE Accounting (0452) syllabus.
• Interpret what a high or low figure for each ratio indicates about the business.
• Make a specific, sensible recommendation linked to each ratio.
• Use the ratios to compare the business with a competitor or an industry benchmark.
• Identify which external parties use each ratio and why.

Why Ratios Are Useful

• They condense large amounts of financial data into a single, comparable figure.
• They enable two types of comparison:
  • Trend analysis – across different years of the same business.
  • Inter‑firm analysis – with another business or the industry average.
• They highlight strengths, weaknesses and emerging trends – essential for decision‑making.

Key Ratios (Cambridge IGCSE 0452)

Formulas are shown in LaTeX between $…$ for inline use.

Who Uses the Ratios and Why?

Limitations of Ratio Analysis

• Ratios are based on historic cost data; they do not reflect current market values.
• Different accounting policies (e.g., inventory valuation, depreciation methods) can make comparisons misleading.
• Ratios ignore qualitative factors such as management competence, brand strength, or economic conditions.
• Seasonal businesses may show distorted ratios if the periods compared are not season‑adjusted.

Step‑by‑Step: Preparing a Comparison Statement

1. Gather data – extract the required figures from the income statement and balance sheet for each year.
2. Calculate the eight ratios for every year under review (use average balances for turnover ratios).
3. Present the results in a clear, labelled table.
4. Write commentary that:
   • Identifies significant changes (increase or decrease).
   • Explains possible reasons (e.g., higher sales, tighter credit policy, new borrowing).
   • Considers the impact on different stakeholders.
   • Provides a specific recommendation linked to each ratio.
5. Optional – Inter‑firm comparison – add a column showing an industry benchmark or a competitor’s figure and comment on the relative performance.

Worked Example – Two‑Year Ratio Comparison

All figures are in £’000 unless otherwise stated.

Calculated Ratios

Sample Commentary Linked to Each Ratio

Gross margin (40 % → 40 %) – No change despite a 20 % rise in sales, indicating that the cost of sales has risen in line with revenue. Recommendation: Review purchasing contracts or consider alternative suppliers to lower the cost of sales and lift the margin.

Profit margin (16 % → 16 %) – The gap between gross and profit margins remains 24 %, showing that operating expenses, interest and tax have increased proportionally with sales. Recommendation: Conduct an expense audit; target overheads that have grown faster than sales (e.g., utilities, admin salaries).

ROCE (30.0 % → 34.3 %) – Improvement reflects higher operating profit with only a modest increase in capital employed. Recommendation: Prioritise projects that generate a return above 34 %; avoid capital‑intensive ventures with lower yields.

Current ratio (1.50 → 1.64) – A healthier short‑term position, mainly because current assets grew faster than current liabilities. Recommendation: Keep a cash buffer of at least 20 % of current liabilities to protect against unexpected outflows.

Acid‑test ratio (1.00 → 1.09) – Liquidity improves even when inventories are excluded, showing that cash and receivables are sufficient to meet current debts. Recommendation: Maintain the current level of liquid assets; avoid converting too much cash into non‑liquid stock.

Inventory turnover (6.67 → 6.55 times) – A slight slowdown indicates cash is being tied up in stock. Recommendation: Implement tighter stock‑control procedures or adopt a just‑in‑time ordering system.

Receivables turnover (14.29 → 13.64 times) – The decline shows slower collection of credit sales. Recommendation: Strengthen credit control – introduce early‑payment discounts or stricter credit limits for slow‑paying customers.

Payables turnover (10.71 → 10.59 times) – The business is paying suppliers marginally faster, which can strain cash. Recommendation: Negotiate longer credit periods with key suppliers where possible, without harming relationships.

Inter‑Firm Comparison (Industry Benchmark)

The company outperforms the industry on profitability and liquidity but lags on inventory and receivables turnover. Improving stock‑control and credit‑policy would free up cash and bring the business in line with industry efficiency.

Checklist for a Good Ratio Comparison Statement

• All figures are taken from the same source (income statement or balance sheet) and refer to the same accounting periods.
• Ratios are calculated correctly, using average balances where required, and rounded appropriately (usually two decimal places for percentages, two for ratios).
• Tables are clearly labelled with year headings, ratio names and units (% or times).
• Commentary:
  • Identifies the direction and magnitude of change for each ratio.
  • Links changes to specific business events (price changes, credit policy, new borrowing, seasonality).
  • Considers the impact on each stakeholder group.
  • Provides at least one actionable recommendation that is directly tied to the ratio being discussed.
• If an inter‑firm comparison is included, the benchmark figures are sourced (industry report, competitor’s published accounts) and the relative performance is explained.