10.2 Analysis of Published Accounts – Financial Ratios (Cambridge IGCSE/A‑Level Business 9609)
Purpose of this Section
- Explain how to extract, calculate and interpret the key financial ratios used to assess a company’s performance.
- Show how ratios link to strategic decision‑making (see 10.4 Strategic Use of Accounts).
- Provide worked examples with realistic £ figures and clear step‑by‑step guidance.
- Highlight limitations and common pitfalls so students can evaluate the reliability of each ratio.
10.2.1 Liquidity Ratios
Current Ratio
Definition: Measures a firm’s ability to meet its short‑term liabilities with its short‑term assets.
Formula
$$\text{Current Ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$$
- Current Assets – cash, stock, trade receivables, short‑term investments.
- Current Liabilities – trade payables, short‑term borrowings, tax payable, accruals.
Calculation Steps
- Read the total current assets from the balance sheet.
- Read the total current liabilities from the balance sheet.
- Divide current assets by current liabilities.
Worked Example
| Item | £ |
|---|
| Current Assets | 210,000 |
| Current Liabilities | 140,000 |
| Current Ratio | 210,000 ÷ 140,000 = 1.5 |
Interpretation
- Ratio > 1 → more current assets than current liabilities – generally a sign of good short‑term solvency.
- Ratio ≈ 2 is often considered “ideal” in many industries, but benchmarks differ.
- Very high ratios may indicate excess cash or stock that could be invested elsewhere.
Limitations
- Ignores the relative liquidity of individual current assets (e.g., inventory may be slow to convert to cash).
- Seasonal fluctuations can distort a single‑year snapshot.
10.2.2 Profitability Ratios
Gross Profit Margin (GPM)
Definition: Shows the proportion of sales left after covering the cost of goods sold (COGS).
$$\text{GPM}=\frac{\text{Gross Profit}}{\text{Sales}}\times100\qquad\text{where}\quad\text{Gross Profit}= \text{Sales}-\text{COGS}$$
Net Profit Margin
$$\text{Net Profit Margin}=\frac{\text{Net Profit}}{\text{Sales}}\times100$$
Return on Capital Employed (ROCE)
$$\text{ROCE}=\frac{\text{Operating Profit (EBIT)}}{\text{Capital Employed}}\times100$$
Capital Employed = Total Assets – Current Liabilities (or Debt + Equity).
Worked Example (All Three Ratios)
| Item | £ |
|---|
| Sales (Revenue) | 800,000 |
| Cost of Goods Sold (COGS) | 480,000 |
| Gross Profit | 320,000 |
| Operating Profit (EBIT) | 120,000 |
| Net Profit | 90,000 |
| Total Assets | 1,200,000 |
| Current Liabilities | 300,000 |
| Capital Employed | 900,000 |
| GPM | 320,000 ÷ 800,000 × 100 = 40 % |
| Net Profit Margin | 90,000 ÷ 800,000 × 100 = 11.25 % |
| ROCE | 120,000 ÷ 900,000 × 100 = 13.3 % |
Interpretation
- Higher GPM → effective control of production/purchasing costs.
- Net Profit Margin reflects overall cost control (including overheads, interest, tax).
- ROCE measures how efficiently capital employed generates profit; useful for comparing with alternative investments.
Limitations
- Accounting policies (e.g., depreciation, inventory valuation) affect the figures.
- One‑off items (asset write‑downs, litigation costs) can distort margins.
- Industry‑specific benchmarks are essential – a “good” margin in retail differs from manufacturing.
10.2.3 Financial‑Efficiency Ratios
1. Inventory Turnover (Rate of Inventory Turnover)
Definition: Indicates how many times a company sells and replaces its stock during a period.
$$\text{Inventory Turnover}=\frac{\text{COGS}}{\text{Average Inventory}}$$
Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2
Calculation Steps
- Locate COGS on the income statement.
- Obtain opening and closing inventory balances from the balance sheet.
- Calculate average inventory.
- Divide COGS by average inventory.
- Convert to “Inventory Days” (optional):
$$\text{Inventory Days}= \frac{365}{\text{Inventory Turnover}}$$
Worked Example
| Item | £ |
|---|
| COGS | 480,000 |
| Opening Inventory | 60,000 |
| Closing Inventory | 90,000 |
| Average Inventory | (60,000 + 90,000) ÷ 2 = 75,000 |
| Inventory Turnover | 480,000 ÷ 75,000 = 6.4 times per year |
| Inventory Days | 365 ÷ 6.4 ≈ 57 days |
Interpretation
- 6.4 turnovers → stock is refreshed roughly every 57 days.
- Higher than industry average → efficient stock control, lower holding costs.
- Lower than average → possible over‑stocking, risk of obsolescence, cash tied up.
- Very high turnover may signal frequent stock‑outs and lost sales.
Limitations
- Depends on COGS, which varies with inventory‑valuation methods (FIFO, LIFO, weighted average).
- Seasonal businesses can obtain misleading averages if a full year is used.
- Does not differentiate between fast‑moving and slow‑moving items within the same inventory pool.
2. Receivables Turnover
Definition: Shows how quickly a firm collects cash from its credit customers.
$$\text{Receivables Turnover}=\frac{\text{Credit Sales}}{\text{Average Trade Receivables}}$$
Average Trade Receivables = (Opening Receivables + Closing Receivables) ÷ 2
Calculation Steps
- Identify credit sales (exclude cash sales) from the income statement.
- Read opening and closing trade receivables from the balance sheet.
- Compute average trade receivables.
- Divide credit sales by the average receivables.
- Convert to “Average Collection Period” (optional):
$$\text{Collection Days}= \frac{365}{\text{Receivables Turnover}}$$
Worked Example
| Item | £ |
|---|
| Credit Sales | 720,000 |
| Opening Trade Receivables | 50,000 |
| Closing Trade Receivables | 70,000 |
| Average Receivables | (50,000 + 70,000) ÷ 2 = 60,000 |
| Receivables Turnover | 720,000 ÷ 60,000 = 12 times per year |
| Collection Days | 365 ÷ 12 ≈ 30 days |
Interpretation
- Higher turnover (shorter collection period) → cash is recovered quickly, reducing financing costs.
- Very high turnover may indicate an overly strict credit policy, possibly losing sales.
- Lower turnover suggests lax credit control and a higher risk of bad debts.
Limitations
- Only credit sales are used; firms with a high cash‑sale proportion may appear to have a low turnover for the wrong reason.
- Seasonal spikes in sales can distort the average receivables figure.
3. Payables Turnover
Definition: Shows how quickly a firm pays its suppliers.
$$\text{Payables Turnover}=\frac{\text{Purchases (or COGS)}}{\text{Average Trade Payables}}$$
Average Trade Payables = (Opening Payables + Closing Payables) ÷ 2
Calculation Steps
- Use total purchases for the period (preferred) or COGS if purchases are not disclosed.
- Read opening and closing trade payables from the balance sheet.
- Calculate average trade payables.
- Divide purchases by average payables.
- Convert to “Average Payment Period” (optional):
$$\text{Payment Days}= \frac{365}{\text{Payables Turnover}}$$
Worked Example
| Item | £ |
|---|
| Purchases (used as proxy for COGS) | 480,000 |
| Opening Trade Payables | 40,000 |
| Closing Trade Payables | 55,000 |
| Average Payables | (40,000 + 55,000) ÷ 2 = 47,500 |
| Payables Turnover | 480,000 ÷ 47,500 ≈ 10.1 times |
| Payment Days | 365 ÷ 10.1 ≈ 36 days |
Interpretation
- Higher turnover (shorter payment period) → the firm pays suppliers quickly, possibly gaining early‑payment discounts but using more cash.
- Lower turnover (longer payment period) → preserves cash, but may strain supplier relationships or forfeit discounts.
Limitations
- If purchases differ markedly from COGS (e.g., large changes in inventory), using COGS can misrepresent the true amount owed.
- Credit terms vary widely across industries; benchmarks must be industry‑specific.
4. Cash Conversion Cycle (CCC)
Definition: The number of days cash is tied up in the operating cycle.
$$\text{CCC}= \text{Inventory Days} + \text{Collection Days} - \text{Payment Days}$$
- Inventory Days = 365 ÷ Inventory Turnover
- Collection Days = 365 ÷ Receivables Turnover
- Payment Days = 365 ÷ Payables Turnover
Worked Example (using figures above)
| Component | Days |
|---|
| Inventory Days | 57 |
| Collection Days | 30 |
| Payment Days | 36 |
| Cash Conversion Cycle | 57 + 30 – 36 = 51 days |
Interpretation
- CCC = 51 days means cash is tied up for about seven weeks before it is recovered from customers.
- Shorter CCC → better liquidity and lower financing needs.
- Very short CCC may indicate aggressive credit terms that could deter customers.
Limitations
- Assumes a steady flow of sales and purchases; seasonal peaks can produce misleading cycles.
- Relies on accurate inventory and receivable valuations.
10.2.4 Working Capital & Sources of Finance
Working Capital
Definition: The amount of short‑term financing a company needs to run its day‑to‑day operations.
$$\text{Working Capital}= \text{Current Assets} - \text{Current Liabilities}$$
Why It Matters
- Positive working capital indicates the firm can meet its short‑term obligations.
- Negative working capital may signal liquidity problems, but some retail models (e.g., fast‑turnover supermarkets) can operate successfully with low working capital.
Sources of Finance (Cambridge Syllabus Requirement)
| Category | Examples | Typical Use |
|---|
| Internal – Retained Earnings | Profits kept in the business | Re‑investment, working‑capital buffer |
| Internal – Sale of Assets | Disposal of surplus equipment | One‑off cash injection |
| External – Short‑term | Overdrafts, trade credit, commercial paper | Seasonal inventory, cash‑flow gaps |
| External – Long‑term | Bank loans, debentures, equity shares, lease financing | Capital‑intensive projects, expansion |
Factors Influencing Choice of Finance
- Cost of finance (interest rate, dividend expectations)
- Control considerations (ownership dilution)
- Risk and security requirements
- Time‑frame of need (short‑term vs long‑term)
- Impact on financial ratios (e.g., gearing, liquidity)
10.2.5 Cash‑Flow Forecasting
Simple Cash‑Flow Statement (Monthly Forecast)
| Month | Cash Inflows (£) | Cash Outflows (£) | Net Cash Flow (£) |
|---|
| Jan | 45,000 | 38,000 | 7,000 |
| Feb | 48,000 | 42,000 | 6,000 |
| Mar | 52,000 | 45,000 | 7,000 |
| … | … | … | … |
Steps to Prepare a Cash‑Flow Forecast
- List all expected cash receipts (sales collections, loan proceeds, asset sales).
- List all expected cash payments (purchases, wages, rent, interest, tax).
- Subtract outflows from inflows for each period to obtain net cash flow.
- Carry forward any opening cash balance to calculate the closing cash balance for each period.
Interpretation & Use
- Identify periods of cash surplus (possible investment) or cash deficit (need for short‑term borrowing).
- Link directly to the Cash Conversion Cycle – a long CCC often creates cash‑flow gaps.
- Support decisions on working‑capital financing and inventory management.
Limitations
- Relies on accurate sales forecasts and timing assumptions.
- Unexpected events (equipment failure, market shock) can render the forecast inaccurate.
10.2.6 Costing, Break‑Even Analysis & Budgets
Cost Classifications
- Fixed Costs (FC): Do not vary with output (e.g., rent, salaries).
- Variable Costs (VC): Vary directly with output (e.g., raw materials, direct labour).
- Total Cost (TC): TC = FC + VC.
Contribution Margin (CM)
$$\text{CM per unit}= \text{Selling Price per unit} - \text{Variable Cost per unit}$$
$$\text{Total CM}= \text{CM per unit} \times \text{Quantity sold}$$
Break‑Even Point (Units)
$$\text{Break‑Even Units}= \frac{\text{Fixed Costs}}{\text{Contribution Margin per unit}}$$
Worked Example
| Item | £ |
|---|
| Selling price per unit | 50 |
| Variable cost per unit | 30 |
| Contribution margin per unit | 20 |
| Fixed costs (annual) | 200,000 |
| Break‑Even Units | 200,000 ÷ 20 = 10,000 units |
| Break‑Even Sales (£) | 10,000 × 50 = 500,000 |
Budgets
Key budgets required for effective financial planning:
- Sales Budget – projected sales volume and value.
- Production / Purchase Budget – units required to meet sales and desired ending inventory.
- Cash Budget – derived from sales and production budgets, shows expected cash position.
- Profit & Loss Budget – combines projected revenues and costs to forecast profit.
Variance Analysis (Budget vs. Actual)
- Favourable variance: Actual result better than budget (e.g., higher profit, lower cost).
- Unfavourable variance: Actual result worse than budget.
- Analyse causes (price changes, efficiency, volume differences) to inform future planning.
10.2.7 Investment Appraisal (A‑Level Requirement)
1. Pay‑Back Period
Time required for cumulative cash inflows to equal the initial outlay.
$$\text{Pay‑Back (years)} = \frac{\text{Initial Investment}}{\text{Annual Net Cash Inflow}}$$
Simple method – does not consider cash flows after the pay‑back point or the time value of money.
2. Accounting Rate of Return (ARR)
$$\text{ARR}= \frac{\text{Average Annual Accounting Profit}}{\text{Initial Investment}}\times100$$
Uses accounting profit rather than cash flow; ignores discounting.
3. Net Present Value (NPV)
$$\text{NPV}= \sum_{t=0}^{n}\frac{C_t}{(1+r)^t}$$
- \(C_t\) = net cash flow in year \(t\) (negative for the initial outlay).
- \(r\) = discount (required) rate.
- \(n\) = project life in years.
Decision rule: Accept if NPV > 0; Reject if NPV < 0.
4. Internal Rate of Return (IRR) – optional for extended study
The discount rate that makes NPV = 0. Compare IRR with the company’s required rate of return.
Worked Example – NPV
| Year | Cash Flow (£) | Discount Factor @ 8 % | Present Value (£) |
|---|
| 0 | -150,000 | 1.000 | -150,000 |
| 1 | 50,000 | 0.926 | 46,300 |
| 2 | 60,000 | 0.857 | 51,420 |
| 3 | 70,000 | 0.794 | 55,580 |
| 4 | 80,000 | 0.735 | 58,800 |
| 5 | 90,000 | 0.681 | 61,290 |
| Total NPV | 23,390 |
Since NPV = £23,390 > 0, the project would be accepted.
Interpretation & Strategic Link
- Investment appraisal directly informs capital‑budgeting decisions covered in 10.4 Strategic Use of Accounts.
- NPV incorporates the cost of capital, aligning project selection with shareholder wealth maximisation.
10.2.8 Gearing Ratio (Financial Leverage)
Definition
Gearing measures the proportion of a company’s capital that is financed by debt rather than equity.
Formula (most common)
$$\text{Gearing Ratio}= \frac{\text{Total Debt (Long‑term + Short‑term)}}{\text{Equity (Share Capital + Reserves)}}\times100$$
Calculation Steps
- Identify total interest‑bearing debt from the balance sheet (loans, bonds, overdrafts).
- Identify total equity (share capital + retained earnings + other reserves).
- Divide debt by equity and multiply by 100 to obtain a percentage.
Worked Example
| Item | £ |
|---|
| Long‑term Debt | 300,000 |
| Short‑term Borrowings | 50,000 |
| Total Debt | 350,000 |
| Share Capital | 400,000 |
| Retained Earnings | 150,000 |
| Total Equity | 550,000 |
| Gearing Ratio | 350,000 ÷ 550,000 × 100 = 63.6 % |
Interpretation
- Higher gearing → greater reliance on debt; potentially higher financial risk but also higher return on equity if profits are strong.
- Lower gearing → more equity‑financed; lower risk but possibly lower returns.
- Industry benchmarks are essential – capital‑intensive sectors (e.g., utilities) normally have higher gearing.
Limitations
- Does not reflect the cost of debt (interest rates) or the terms of repayment.
- Equity may include re‑valuation reserves that are not readily available to shareholders.
- Snapshot nature – does not show trends over time.
10.2.9 Linking Ratios to Strategic Decision‑Making (Preview of 10.4)
- Liquidity ratios guide short‑term financing and working‑capital policies.
- Profitability ratios help assess product‑line performance and pricing strategy.
- Efficiency ratios (inventory, receivables, payables) influence operational tactics such as stock‑holding policies, credit terms and supplier negotiations.
- Gearing informs long‑term financing choices and risk assessment.
- Investment appraisal tools (NPV, IRR) are used to evaluate major capital projects that affect future ratios.
Understanding how each ratio interacts with the others enables students to evaluate the overall financial health of a business and to recommend strategic actions that improve performance.