Analysis of Published Accounts – Ratio Analysis (Cambridge 9609)
1. Introduction
Ratio analysis converts raw figures from the profit‑and‑loss account (P&L) and the statement of financial position (balance sheet) into percentages or multiples. It enables candidates to:
- Assess profitability – how well capital is turned into profit.
- Evaluate liquidity – the ability to meet short‑term obligations.
- Measure financial efficiency – the effectiveness of asset use.
- Analyse gearing – the balance between debt and equity financing.
- Judge investment performance – returns to shareholders.
All ratios must be derived from figures that appear in the published accounts, so it is essential to know where each number comes from.
2. Profitability Ratios
2.1 Return on Capital Employed (ROCE)
Purpose: Shows how efficiently a company generates operating profit from the capital that is employed in the business.
Formula
$$\text{ROCE} = \frac{\text{Operating Profit (EBIT)}}{\text{Capital Employed}} \times 100\%$$
Where
- Operating Profit (EBIT) – profit before interest and tax. In the P&L it is the line “Profit before tax” plus any interest expense.
- Capital Employed – total capital used to generate profit. Two equivalent ways to calculate it:
- Capital Employed = Fixed Assets (net) + Working Capital
- Capital Employed = Total Assets – Current Liabilities
- Working Capital = Current Assets – Current Liabilities.
2.2 Gross Profit Margin
Purpose: Indicates the proportion of sales left after covering the cost of goods sold (COGS); a measure of production/purchasing efficiency.
Formula
$$\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100\%$$
Gross Profit = Sales – COGS (both taken from the P&L).
2.3 Net Profit Margin (Profit Margin)
Purpose: Shows overall profitability after all expenses, interest and tax.
Formula
$$\text{Net Profit Margin} = \frac{\text{Net Profit}}{\text{Sales}} \times 100\%$$
Net Profit = the bottom‑line figure after tax in the P&L.
2.4 Return on Equity (ROE)
Purpose: Measures the return generated for shareholders’ equity.
Formula
$$\text{ROE} = \frac{\text{Net Profit}}{\text{Average Shareholders’ Equity}} \times 100\%$$
Average Shareholders’ Equity = (Equity at start of period + Equity at end of period) ÷ 2 (taken from the balance sheet).
3. Liquidity Ratios
3.1 Current Ratio
Formula
$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$
A ratio ≥ 1 indicates that current assets can cover current liabilities.
3.2 Acid‑Test (Quick) Ratio
Formula
$$\text{Acid‑Test Ratio} = \frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}}$$
Inventories are excluded because they may not be quickly convertible to cash.
4. Financial‑Efficiency Ratios
4.1 Inventory Turnover
Formula
$$\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$$
Average Inventory = (Opening inventory + Closing inventory) ÷ 2.
4.2 Receivables Turnover
Formula
$$\text{Receivables Turnover} = \frac{\text{Credit Sales}}{\text{Average Trade Receivables}}$$
Often expressed as days: Days Sales Outstanding = 365 ÷ Receivables Turnover.
4.3 Payables Turnover
Formula
$$\text{Payables Turnover} = \frac{\text{Purchases (or COGS)}}{\text{Average Trade Payables}}$$
Days Payables Outstanding = 365 ÷ Payables Turnover.
5. Gearing Ratio
Purpose: Indicates the proportion of a company’s capital that is financed by debt.
Formula (Debt‑to‑Equity)
$$\text{Gearing Ratio} = \frac{\text{Total Borrowings}}{\text{Total Shareholders’ Equity}}$$
Borrowings = long‑term loans + the current portion of long‑term debt (balance‑sheet items).
6. Investment Ratios
6.1 Dividend Yield
$$\text{Dividend Yield} = \frac{\text{Dividends per Share}}{\text{Market Price per Share}} \times 100\%$$
6.2 Dividend Cover
$$\text{Dividend Cover} = \frac{\text{Profit After Tax per Share}}{\text{Dividends per Share}}$$
6.3 Price‑Earnings (P/E) Ratio
$$\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings per Share (EPS)}}$$
7. Where the Data Comes From
| Ratio |
P&L Items |
Balance‑Sheet Items |
| ROCE, ROE, Net Profit Margin |
Operating profit (EBIT), Net profit, Sales, COGS |
Fixed assets (net), Current assets, Current liabilities, Total assets, Shareholders’ equity |
| Gross Profit Margin |
Sales, COGS |
– |
| Current & Acid‑Test Ratios |
– |
Current assets, Inventories, Current liabilities |
| Inventory, Receivables, Payables Turnover |
COGS, Credit sales, Purchases |
Opening/closing inventories, Trade receivables, Trade payables |
| Gearing |
– |
Total borrowings, Shareholders’ equity |
| Dividend Yield, Cover, P/E |
Dividends, Profit after tax, EPS |
Market price per share (external source) |
8. Example Calculations (All figures are for the same period)
| Item | Amount (£) |
|---|
| Sales (Revenue) | 300,000 |
| Cost of Goods Sold (COGS) | 180,000 |
| Operating Profit (EBIT) | 45,000 |
| Net Profit (after tax) | 30,000 |
| Fixed Assets (net) | 120,000 |
| Current Assets | 40,000 |
| Inventories | 15,000 |
| Current Liabilities | 10,000 |
| Trade Receivables – end | 12,000 |
| Trade Receivables – start | 10,000 |
| Trade Payables – end | 8,000 |
| Trade Payables – start | 6,000 |
| Shareholders’ Equity – end | 90,000 |
| Shareholders’ Equity – start | 80,000 |
| Total Borrowings | 30,000 |
| Dividends per Share | 0.50 |
| Market Price per Share | 5.00 |
| Number of Shares (assumed) | 10,000 |
Key Calculations
- Working Capital = 40,000 – 10,000 = 30,000
- Capital Employed = 120,000 + 30,000 = 150,000
- ROCE = 45,000 ÷ 150,000 × 100 = 30 %
- Gross Profit = 300,000 – 180,000 = 120,000 → Gross Profit Margin = 120,000 ÷ 300,000 × 100 = 40 %
- Net Profit Margin = 30,000 ÷ 300,000 × 100 = 10 %
- Average Equity = (90,000 + 80,000) ÷ 2 = 85,000 → ROE = 30,000 ÷ 85,000 × 100 = 35.3 %
- Current Ratio = 40,000 ÷ 10,000 = 4.0
- Acid‑Test Ratio = (40,000 – 15,000) ÷ 10,000 = 2.5
- Average Inventory = (15,000 + 15,000) ÷ 2 = 15,000 → Inventory Turnover = 180,000 ÷ 15,000 = 12 times
- Average Receivables = (12,000 + 10,000) ÷ 2 = 11,000 → Receivables Turnover = 300,000 ÷ 11,000 ≈ 27.3 times (≈13.4 days)
- Average Payables = (8,000 + 6,000) ÷ 2 = 7,000 → Payables Turnover = 180,000 ÷ 7,000 ≈ 25.7 times (≈14.2 days)
- Gearing Ratio = 30,000 ÷ 90,000 = 0.33 (33 %)
- Dividend Yield = 0.50 ÷ 5.00 × 100 = 10 %
- EPS = 30,000 ÷ 10,000 = £3.00 → Dividend Cover = 3.00 ÷ 0.50 = 6.0
- P/E Ratio = 5.00 ÷ 3.00 ≈ 1.67
9. Interpretation of the Ratios
- ROCE 30 % (vs. typical WACC ≈ 8 %): The business creates value; each £1 of capital generates £0.30 operating profit.
- Gross Profit Margin 40 %: Good control over production/purchasing costs; compare with industry norms.
- Net Profit Margin 10 %: After all expenses the firm retains £0.10 of profit per £1 of sales.
- ROE 35 %: Very attractive return for shareholders, but check whether it is driven by high financial leverage.
- Current Ratio 4.0 & Acid‑Test 2.5: Strong short‑term liquidity; excess cash may be idle.
- Inventory Turnover 12 ×: Inventory is sold roughly every month – efficient stock management.
- Receivables Turnover 27 × (13 days): Customers pay quickly, reducing cash‑conversion risk.
- Payables Turnover 26 × (14 days): The firm settles suppliers promptly; may be missing out on credit terms.
- Gearing 33 %: Moderate debt level; lower financial risk than highly‑geared firms.
- Dividend Yield 10 % & Cover 6.0: Attractive dividend with ample profit to sustain it.
- P/E Ratio 1.67: The market values the company at less than two times earnings – could indicate undervaluation or market concerns.
10. Strategic Relevance of the Ratios
- Performance monitoring – Management tracks ROCE, ROE and profit margins to judge whether current strategies (pricing, cost control, investment) are delivering value.
- Investment appraisal – A new project is only undertaken if its expected ROCE exceeds the company’s cost of capital and improves the overall ROCE.
- Financing decisions – The gearing ratio helps decide whether to raise additional capital through debt or equity, balancing risk and return.
- Shareholder relations – Dividend yield, cover and P/E influence dividend policy and share‑price expectations.
- Benchmarking – Comparing each ratio with industry averages or with the firm’s own historical trends highlights competitive strengths and weaknesses.
11. Limitations of Ratio Analysis
- Ratios are based on historical financial statements; they do not predict future performance.
- Different accounting policies (e.g., depreciation methods, inventory valuation) can make comparisons misleading.
- Seasonal businesses may show distorted ratios if only one year’s data is used.
- Ratios ignore qualitative factors such as brand strength, management quality, or market conditions.
- Specific cautions:
- ROCE can be inflated by large asset write‑downs that reduce capital employed.
- Profit margins may be affected by one‑off gains or losses.
- Liquidity ratios may appear healthy if a firm holds large cash balances that are not needed for operations.
- Gearing does not reflect the terms of debt (interest rates, covenants).