RATIO ANALYSIS – (AS Level)

(1) Profitability Ratios

(i) Mark up Gross Profit
= × 100
Cost of Sales
Income statement Ratios
(ii) Gross Profit Ratio (Margin) Gross Profit
= × 100
Net Sales
(iii) Net Profit Ratio Profit after interest
= × 100
Net Sales (Revenue)

(iv) Operating Expenses Ratio Operating Expenses

= × 100
Net Sales (Revenue)
Profit Before interest
= × 100
Capital Employed
(v) Return on Capital Employed
[Capital Employed = Issued Shares + Reserves + Long Term
Liabilities (Non-Current Liabilities)]
Capital Employed = Equity + Non-Current Liabilities
(2) Turnover/Efficiency Ratios
Cost of Sales
(i) Inventory Turnover Rate (times) =
Average Inventory
Net Sales
(ii) Non-current Assets Turnover (times) =
Net Book Value of Non−Current Assets
Average Inventory
(iii) Inventory Turnover Rate (days) = × 365
Cost of Sales
Average age of trade receivables/Trade Trade Receivables
(iv) = × 365
receivables Collection Period (days) Credit Sales

Average age of trade payables/Trade Trade Payables

(vi) = × 365
payables Payment Period (days) Credit Purchases

(3) Liquidity Ratios

Current Assets
(i) Current ratio/Working Capital Ratio =
Current Liabilities
Current Assets− Inventory
(ii) Quick/Acid Test/Liquid/Liquidity Ratio =
Current Liabilities

Uses of Ratio analysis

• Ratios help in analysing the performance trends over a long period of time.
• They also help a business to compare the financial results to those of competitors.
• Ratios assist the management in decision making.
• They also point out problem and week areas along with the strength areas.
• Ratios help to develop relationships between different financial statement items.
• Ratios have the advantage of controlling for differences in size.

Limitations of ratio analysis

• Ratio analysis requires a proper comparison i.e. a ratio is of no use unless it is compared to last year’s or other firms’
figures, etc.
• Comparison with last year’s or with competitors may be invalid comparisons as firms can use different accounting
policies & methods.
• Ratios are based on historical figures (not adjusted for inflation) so the conclusions drawn from them may be
misleading & unrealistic.
• Each industry has different standards for different ratios to be adhered to. ( totally outside the entity's control) Nov
11 P1 Q24

Current ratio Liquid ratio

sale of non-current assets  
Sale of inventory Marginal  (if on profit) 
Purchases inventory on credit. (if above1:1)  
Purchases inventory by cheque No effect 
issue of more share capital for cash  
replacing machinery earlier than planned  
increases its provision for doubtful debts  
using cash at bank to pay creditors  
trade receivables’ collection period
a large bad debt written off 
a large credit sale made just before the year-end 
a major customer in financial difficulty 
poor credit control 
Customers took advantage of cash discounts 
The company entered into a debt factoring arrangement. 

Gross profit ratio

purchases have been obtained at reduced cost 
an over-valuation of opening inventory 
an over-valuation of closing inventory 
charging a higher selling price than its rivals 
a supermarket is likely to have the lowest Gross Profit/ Sales margin
a retail department store business should have the highest non-current asset turnover

QUESTION 17 NOVEMBER 2008 P2 Q2 (B), NOVEMBER 2013 P21 Q2

Ratio Formula What the ratio Measures Why the ratio may Change
➢ Change in sales prices
➢ Change in cost prices without
corresponding change in sales
price.
➢ Buying in larger or smaller
quantities resulting in higher or
It tests the trading
lower trade discounts
performance of the business in
➢ Stolen inventory not deducted
Gross profit Gross Profit terms of its profitability in
x 100 from purchases.
ratio Net Sales relation to sales.
➢ Price cuts for disposing off old
.
inventory.
➢ incorrect stock valuation
➢ more sale of higher or lower
margin items
➢ increased carriage on purchases
not passed on to customers,
breakages, embezzlement etc.
 It tests the overall Higher or lower administrative and
performance of the business in marketing expenses
Net profit Net Profit
x 100 terms of its profitability in All points listed in Gross profit
ratio Net Sales
relation to sales. margin

changes in demand levels

Determines how frequently decreased by quality of inventory,
business is on average, able to damage to inventory, fashion
Inventory Cost of goods sold rotate and sell its inventory changes, obsolescence etc or
turnover Average inventory during the year. increase in demand levels by
. advertising, reduced margins or by
sales promotions etc.

working capital may increase Sales

of surplus non-current assets
This shows amount available Borrowing on long term basis
Working Current Assets –
to the business for meeting Injection of additional capital by
Capital Current Liabilities day to day expenses the owner
Reduction in drawings

The Current Ratio expresses

the relationship between the Too low ratio may lead to
firm’s current assets and its insolvency BUT too high ratio
current liabilities that how indicates inefficient use of
much cents worth of current investment within the business
assets for every dollar of since current assets are not as
Current ratio
Current Assets current liabilities. The rule of profitable as fixed assets are. So
or Working
Current Liabilities thumb says that the current the too high ratio may indicate
Capital Ratio
ratio should be in between 1.5: poor management of current
1 to 2.0:1. that is the current assets e.g. too high bank balance
assets should meet current indicates that funds remain idle
liabilities in between 1.5 to 2.0 and are not being used to the best
time. advantage.

determines the short term

solvency of the business. Tells Affected by changes in liquid assets
about the ability of a business like cash, bank, and trade
Quick (acid Current assets−inventory
to satisfy its current receivables or by current liabilities
test) Ratio Current liabilities
obligations from liquid current like trade payables.
assets.
Affected by any increase or
Determines the overall decrease in profit or in capital
profitability of the business employed. For instance, better
and the efficiency to generate control of expenses would increase
Return on profits from capital employed profitability.
Profit before interest
capital x100 within the business. Affected by any increase or
Capital employed
employed Tests the profitability of the decrease in profit or in capital
business and the efficiency to employed. For instance, better
generate profits from capital. control of expenses would increase
. profitability
 Increase in ratio suggests that
Determines efficiency of a
Trade credit customers are taking longer
business in terms of time it
receivables to pay. It can be controlled by
takes to collect cash from its
turnover Trade receivables personal efforts, introducing cash
x 365 credit customers.
(average Credit sales discounts for prompt payment,
Thought of as how long
collection hiring of additional staff for debt
resources are tied up in debt.
period) collection etc.
Is compared to previous years
Increase in ratio suggests that the
Trade company is taking longer to pay
A short-term liquidity measure
payables off its suppliers than it was before.
used to quantify the rate at
turnover Trade payables The opposite is true when the
x 365 which a company pays off its
(average Credit purchases payment period is falling, which
credit suppliers.
payment means that the company is paying
period) of suppliers at a faster rate.

QUESTION 1 MAY 2013 P22 Q1

The following information relates to two businesses, one of which manufactures computers whilst the other is a food
wholesaler. All sales and purchases are on credit.

Business X Business Y
Gross profit ratio 54% 30%
Net profit ratio 18% 6%
Current ratio 1.6:1 0.5:1
Trade receivables turnover 40 days 3 days
Return on capital employed 5.4% 12%
Cost of sales $248 400 $1 050 000
Closing inventory $38 000 $48 000
Cash and cash equivalents $30 000 $14 000
Long-term loan $1 000 000 $50 000
For calculations, assume a 360-day year.
REQUIRED
(a) State and explain which business is the computer manufacturer & which is the food wholesaler. [3]
(b) Prepare, as fully as the given information allows, income statements for both businesses [8]
(c) Prepare, as fully as the given information allows, statements of financial position for both businesses. [12]

QUESTION 2 MAY 1997 P1 Q5 (A)

J. Peters is considering purchasing the total share capital of a small trading company, Kings Lyne Limited.
The company’s accountants have supplied the following information concerning Kings Lyne Limited. In the absence
of the company’s final accounts, the following accounting ratios and related information for the year ended 31 March 1997
have been produced:
Sales $440 000
Gross Profit / Sales 25%
Variable Overheads / Sales 15%
Net Profit / Sales 5%
Inventory Turnover (Using the average of opening and closing inventories) 15
Return on Capital employed (Using non-current Assets plus Working Capital) 11%
Acid test ratio 4:1
Non-current Assets as at 31 March 1997 $140 000
Trade receivables as at 31 March 1997 $42 000
On 31 March 1997, King Lyne Limited issued $14 000 7% Loan Inventory 2005/2007 at par. Kings Lyne Limited has
not paid any dividends since 1994. Company had $100 000 as issued share capital and a retained earnings balance
of $64 000 on 31 March 1996.
Inventory at 31 March 1996 was $20 000.
Required
Prepare the Income statement for the year ended 31 March 1997 and a Balance Sheet as at that date in as much
relevant detail as possible.
QUESTION 3 MAY 2010 P21 Q2
C's gross profit margin shows that she makes more gross profit for every dollar of sales.
C's net profit margin shows that she makes more net profit for every dollar of sales.
C's return on total assets shows that for every dollar's worth of total assets in the business
she receives a better return than D does.
C's return on capital employed shows that for every dollar she has invested in the business
she receives more profit in return.
C's current ratio shows that she is more able to pay her short term debts.
C's liquid ratio shows that she is more able to pay her immediate debts.
C's debtors' turnover shows that she collects debt faster so that cash becomes available sooner.
C's creditors' turnover shows that she is given longer to pay her debts and has more time to make use of her
creditors' cash.
C's inventory return rate (rate of stock turn) shows that she sells her goods faster and should therefore make her
profits faster.
Any four of the above answers for a maximum of 3 marks each.

QUESTION 4 MAY 2011 P22 Q2 (b & c)

One mark each for better or worse (poorer) than – maximum 5 marks
1. Northern has a better mark up.
2. Consequently a better gross profit percentage.
3. Expenses to sales is worse for Northern.
4. Net profit percentage for Northern is poorer.
5. Northern’s ROCE is poorer.
Must be clear that one is better than the other – do not accept higher, lower, greater, lesser, more, less.
Some candidates have treated the comparisons as if they were for the same business over 2 years – do not accept.
One mark each for each valid comment – maximum 5
Sales price is higher – higher mark up.
Administration and advertising costs are higher to sell a higher priced product.
Northern has a better GP percentage but the higher expenses incurred pull down the net profit advantage below
Southern and contribute to a poorer ROCE.
The ROCE is poorer because Northern may have more non-current assets employed.
Any valid comment is acceptable provided it justifies the “better or worse” statement.
A maximum of 1 mark for each statement and 1 mark for an attached comment.
QUESTION 5 NOVEMBER 2011 P22 Q2 (B)
S Turner is considering expanding her business by purchasing another food wholesale business.
She has obtained the following information on two possible business purchases.
Paradise Foods Jones Wholesalers
Return on capital employed 15% 6%
Current ratio 3.4:1 1.8:1
Liquid (acid test) ratio 0.5:1 1.4:1
REQUIRED
(c) Advise which business, if any, she should purchase on the basis of all of the information provided. Justify
your answer. [4]
Question 5 November 2011 P22 Q2B (c)
Paradis Foods
1. The return on capital employed is high at 15%. It is higher than S Turner is currently obtaining.
2. The current ratio is good and possibly too high with excess stock. The level of the current ra tio is well in
excess of S Turners’.
3. The liquid ratio seems low for a general trading business.
Jones Wholesaler
1. The return on capital employed is low at 6%. It is much lower than S Turner is currently obtaining.
2. The current ratio is good and within the range of 1.5 and 2.0 that we would expect to see.
3. The liquid ratio is high at 1.4 : 1 indicating high debtors or cash. (Any three points – 1 each + 1of for
decision) [4]

Question 6 May 2011 P23 Q1 (f)

Inventory is regarded as the least liquid asset as a buyer has to be found whereas some goods may prove
to be unsaleable
The quick ratio shows if the business would have any surplus liquid funds if all the current liabilities were
paid immediately
Any two suitable points 1 mark each

QUESTION 7 MAY 2012 P21 Q2(d & e)

Jackie and Kim provided the following accounting ratios:
Year ended 30 April 2011 Year ended 30 April 2012
Percentage of gross profit to sales 21% 24%
Percentage of net profit to sales 10% 11%

REQUIRED
(d) Suggest two reasons for the change in the percentage of gross profit to sales. [4]
(e) Suggest two reasons for the change in the percentage of net profit to sales. [4]

QUESTION 7 MAY 2012 P21 Q2(d & e)

(d) Higher sales price with cost of sales staying same or rising less than sales price.
Lower cost of sales with sales price staying same or falling less than cost of sales.
More efficient use of stock with less spoilage, wastage and theft
NOTE: increase in sales volume is incorrect.
1 mark per point, one for development to maximum of 4 [4]

(e) Lower overhead costs such as rent, rates, heat and light.
Increased efficiency (lower costs)
Higher gross profit margin with overheads remaining the same or less than percentage increase in GP to
sales.
1 mark per point, one for development to maximum of 4 [4]
Question 8 May 2015 P23 Q2 (b)
(i) Inventory turnover is slow. This suggests low sales which impacts on profit and cash flow. There will be higher
holding costs including the risk of obsolescence. [3]
(ii) Customers are paying after the credit terms.
This suggests poor credit control procedures.
Cash flow will be slower and there will be a higher risk of bad debts. [3]
(iii) Suppliers are being paid early. This adversely affects cash flow especially as suppliers are being paid before
customers pay. It is likely however that prompt payment cash settlement discounts will be available.
[1 mark for valid point to max 3 in each case] [3]
Suggested Questions SPECIMEN 2016 P2 Q1 (a to c)