Students will be able to calculate, interpret and critically evaluate the five groups of ratios required by the Cambridge A‑Level Business syllabus, to link the results to strategic actions and to recommend measures that improve a company’s profitability.
Liquidity ratios assess a company’s ability to meet its short‑term obligations.
| Ratio | Formula | Interpretation | Limitations | Typical Improvement Actions |
|---|---|---|---|---|
| Current Ratio (CR) | \(\displaystyle \text{CR}= \frac{\text{Current Assets}}{\text{Current Liabilities}}\) | Number of pounds of current assets available for each pound of current liability. A ratio ≥ 2 is often regarded as safe for many industries. | Ignores the differing liquidity of individual current‑asset items; seasonal fluctuations can distort the figure. |
• Tighten credit terms or introduce early‑payment discounts. • Reduce excess stock (e.g., adopt JIT). • Negotiate longer payment terms with suppliers. • Use seasonal adjustments when analysing businesses with strong seasonality. |
| Acid‑Test (Quick) Ratio (QR) | \(\displaystyle \text{QR}= \frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}}\) | Measures ability to meet short‑term debts without relying on inventory. A ratio ≥ 1 is generally satisfactory. | Assumes all non‑inventory current assets can be instantly converted to cash. |
• Increase cash balances or short‑term investments. • Reduce slow‑moving inventory. • Use factoring for receivables. |
| Cash Ratio (CRa) | \(\displaystyle \text{CRa}= \frac{\text{Cash} + \text{Cash Equivalents}}{\text{Current Liabilities}}\) | Shows the extent to which cash alone can cover current liabilities – the most conservative liquidity measure. | Often very low for healthy firms because cash is deliberately limited to earn returns elsewhere. |
• Maintain a cash buffer appropriate to the firm’s risk profile. • Convert excess marketable securities into cash when liquidity risk rises. |
Profitability ratios indicate how efficiently a business turns sales into profit.
| Ratio | Formula | Interpretation | Limitations | Typical Improvement Actions |
|---|---|---|---|---|
| Gross Profit Margin (GPM) | \(\displaystyle \text{GPM}= \frac{\text{Gross Profit}}{\text{Sales}} \times 100\) | Proportion of sales left after covering the cost of goods sold (COGS). Higher values indicate better control of production/purchasing costs. | Distorted by changes in inventory valuation (FIFO/LIFO) and one‑off price changes. |
• Negotiate cheaper raw‑material contracts. • Implement lean production techniques. • Shift product mix towards higher‑margin items. |
| Operating Profit Margin (OPM) | \(\displaystyle \text{OPM}= \frac{\text{Operating Profit}}{\text{Sales}} \times 100\) | Profitability after all operating expenses but before interest and tax. Highlights cost‑control beyond COGS. | Ignores financing structure and tax effects; can be affected by depreciation policy. |
• Reduce overheads (rent, utilities). • Automate repetitive processes. • Outsource non‑core activities. |
| Net Profit Margin (NPM) | \(\displaystyle \text{NPM}= \frac{\text{Net Profit}}{\text{Sales}} \times 100\) | Final profit retained from each pound of sales after all expenses, interest and tax. | Highly sensitive to tax rates and interest costs, which may vary for reasons unrelated to operating performance. |
• Re‑finance debt at lower rates. • Implement tax‑efficient structures (where legal). • Control both operating and non‑operating costs. |
| Return on Capital Employed (ROCE) | \(\displaystyle \text{ROCE}= \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100\) | Efficiency of capital (equity + long‑term debt) in generating operating profit. A higher ROCE signals better asset utilisation. | Definition of capital‑employed can vary; depreciation methods affect operating profit. |
• Dispose of under‑used assets. • Increase capacity utilisation. • Shift to higher‑margin activities. |
| Return on Equity (ROE) | \(\displaystyle \text{ROE}= \frac{\text{Net Profit}}{\text{Shareholders' Equity}} \times 100\) | Return generated for shareholders; useful for investors comparing profitability across firms. | Can be inflated by high financial leverage; does not reflect risk. |
• Increase net profit (see profitability actions). • Consider share buy‑backs to reduce equity base. • Maintain an optimal debt‑to‑equity mix. |
| Return on Assets (ROA) (optional – often appears in past papers) | \(\displaystyle \text{ROA}= \frac{\text{Net Profit}}{\text{Total Assets}} \times 100\) | Shows how efficiently a company uses all of its assets to generate profit. | Ignores the source of financing; can be skewed by large non‑productive asset bases. |
• Improve asset utilisation (e.g., increase inventory turnover). • Dispose of idle assets. • Invest in higher‑return projects. |
These ratios examine how well a business manages its working‑capital components.
| Ratio | Formula | Interpretation | Limitations | Typical Improvement Actions |
|---|---|---|---|---|
| Inventory Turnover (IT) | \(\displaystyle \text{IT}= \frac{\text{COGS}}{\text{Average Inventory}}\) | Number of times inventory is sold and replaced in a period. Higher turnover implies efficient stock control. | Seasonal businesses may show low turnover in off‑peak periods; does not reveal obsolescence. |
• Adopt Just‑In‑Time (JIT) or Vendor‑Managed Inventory. • Review product range to eliminate slow‑moving items. |
| Average Collection Period (ACP) – “Days Sales Outstanding” | \(\displaystyle \text{ACP}= \frac{\text{Average Trade Receivables}}{\text{Credit Sales}} \times 365\) | Average number of days taken to collect cash from credit customers. Shorter periods improve cash flow. | Assumes credit sales are evenly spread throughout the year; may hide credit‑risk issues. |
• Tighten credit policy or offer early‑payment discounts. • Use automated invoicing and reminders. • Perform credit checks on new customers. |
| Receivables Turnover (RT) | \(\displaystyle \text{RT}= \frac{\text{Credit Sales}}{\text{Average Trade Receivables}}\) | Shows how many times credit sales are collected in a period. Higher turnover = better cash flow. | Ignores credit risk; high turnover may be achieved by overly strict terms that deter customers. |
• Same actions as ACP (tighten policy, discounts, automation). • Review and segment customers by risk. |
| Average Payment Period (APP) – “Days Payables Outstanding” | \(\displaystyle \text{APP}= \frac{\text{Average Trade Payables}}{\text{Purchases}} \times 365\) | Average number of days the firm takes to pay its suppliers. Longer periods free cash but may strain supplier relations. | Does not consider negotiated payment terms; extremely long periods can damage credit standing. |
• Negotiate longer payment terms. • Use supply‑chain financing or trade credit insurance. • Balance cash‑flow benefits against supplier goodwill. |
| Payables Turnover (PT) | \(\displaystyle \text{PT}= \frac{\text{Purchases}}{\text{Average Trade Payables}}\) | Indicates how fast a company pays its suppliers. Lower turnover = longer payment period. | Same limitations as APP; can be misleading if purchases fluctuate sharply. |
• Same actions as APP (renegotiate terms, financing options). • Align payment schedule with cash‑inflow cycles. |
Gearing ratios reveal the proportion of a company’s financing that comes from debt versus equity.
| Ratio | Formula | Interpretation | Limitations | Typical Improvement Actions |
|---|---|---|---|---|
| Debt‑to‑Equity Ratio (D/E) | \(\displaystyle \text{D/E}= \frac{\text{Total Debt}}{\text{Total Equity}}\) | Shows the relative weight of creditors versus shareholders. A lower ratio generally means lower financial risk. | Does not reflect the cost of debt; acceptable levels vary by industry. |
• Repay high‑cost debt. • Issue new equity (if dilution is acceptable). • Convert short‑term debt to long‑term debt to improve stability. |
| Interest‑Cover Ratio (ICR) | \(\displaystyle \text{ICR}= \frac{\text{Operating Profit}}{\text{Interest Expense}}\) | Measures ability to meet interest payments. An ICR ≥ 3 is often viewed as comfortable. | Ignores principal repayments; can be inflated by one‑off gains. |
• Reduce interest expense through refinancing. • Increase operating profit (see profitability actions). • Consider temporary interest‑only loan structures if cash‑flow is tight. |
Investment ratios are of interest to shareholders and potential investors.
| Ratio | Formula | Interpretation | Limitations | Typical Improvement Actions |
|---|---|---|---|---|
| Dividend Yield (DY) | \(\displaystyle \text{DY}= \frac{\text{Dividend per Share}}{\text{Market Price per Share}} \times 100\) | Cash return to shareholders relative to the share price. Attractive to income‑seeking investors. | Depends on market‑price volatility; a high yield may result from a falling share price. |
• Maintain a stable, sustainable dividend policy. • Communicate growth prospects to support share price. |
| Dividend Cover (DC) | \(\displaystyle \text{DC}= \frac{\text{Net Profit}}{\text{Total Dividends Paid}}\) | Shows how many times profit covers the dividend. A cover ≥ 2 is usually considered safe. | Ignores retained‑earnings needs for reinvestment. |
• Retain a higher proportion of earnings for reinvestment. • Adjust dividend policy in line with profitability trends. |
| Price‑Earnings Ratio (P/E) | \(\displaystyle \text{P/E}= \frac{\text{Market Price per Share}}{\text{Earnings per Share}}\) | Reflects market expectations of future earnings growth. High P/E suggests growth expectations; low P/E may indicate undervaluation or poor prospects. | Affected by accounting choices, one‑off items and market sentiment; not comparable across industries. |
• Communicate a clear growth strategy to justify a higher P/E. • Improve earnings consistency and transparency. |
Ratios highlight where performance is weak; the actions below address the underlying causes and move the ratios in a favourable direction.
By interpreting each ratio in the context of the business’s environment, students can recommend concrete, financially‑sound strategies that move the ratios in a favourable direction and, consequently, improve overall profitability.
Assume the following simplified figures for XYZ Ltd. (all amounts in £‘000):
| Item | Amount |
|---|---|
| Sales (Revenue) | 500 |
| Cost of Goods Sold (COGS) | 300 |
| Gross Profit | 200 |
| Operating Expenses (incl. depreciation) | 120 |
| Operating Profit | 80 |
| Interest Expense | 20 |
| Tax (20 % of profit before tax) | 12 |
| Net Profit | 68 |
| Current Assets | 150 |
| Inventories | 60 |
| Cash & Cash Equivalents | 30 |
| Current Liabilities | 80 |
| Average Trade Receivables | 40 |
| Credit Sales (assume 80 % of total sales) | 400 |
| Average Trade Payables | 35 |
| Purchases (assume equal to COGS) | 300 |
| Total Debt | 120 |
| Total Equity | 200 |
| Capital Employed (Debt + Equity) | 320 |
| Total Assets | 420 |
Key ratio calculations
Interpretation & Suggested Actions for XYZ Ltd.
Implementing the actions above would be expected to raise the current ratio, improve operating profit margin, shorten the collection period and ultimately increase ROCE and ROE – all clear evidence of enhanced profitability.
Create an account or Login to take a Quiz
Log in to suggest improvements to this note.
Your generous donation helps us continue providing free Cambridge IGCSE & A-Level resources, past papers, syllabus notes, revision questions, and high-quality online tutoring to students across Kenya.