Chapter 6: Analysis and Interpretation — Part 1

01 Profitability Ratios

These ratios measure a firm’s success in generating profit relative to its sales or capital investment.

1.1.1 Gross Margin

• Formula: (Gross Profit ÷ Revenue) × 100.
• Purpose: Measures the efficiency of the firm’s trading activities and its ability to control the cost of sales.
• Worked Example: Using data where Revenue is $67,865 and Gross Profit is $29,703:
  Calculation: (29,703 / 67,865) × 100 = 43.77%

1.1.2 Profit Margin

• Formula: (Profit for the year ÷ Revenue) × 100.
• Purpose: Measures the efficiency of the business in controlling its operating expenses (overheads).
• Worked Example: Using data where Revenue is $67,865 and Profit for the year is $13,336:
  Calculation: (13,336 / 67,865) × 100 = 19.65%

1.1.3 Return on Capital Employed (ROCE)

• Formula: (Profit for the year before interest ÷ Capital employed) × 100.
• Capital Employed Calculation: Issued Shares + Reserves + Non-Current Liabilities.
• Purpose: This is the primary measure of overall profitability. It shows how much profit is generated for every $100 of long-term capital invested in the business.
• Worked Example: Profit for the year before interest is $24,000. Capital employed = Issued shares $50,000 + Reserves $30,000 + Debentures $20,000 = $100,000.
  Calculation: (24,000 / 100,000) × 100 = 24%

1.1.4 Mark-up

• Formula: (Gross Profit ÷ Cost of sales) × 100.
• Significance: Frequently used in pricing and for calculating missing figures when records are incomplete.

02 Liquidity Ratios

Liquidity ratios assess the business’s ability to pay its short-term debts (current liabilities) as they fall due.

1.2.1 Current Ratio

• Formula: Current Assets ÷ Current Liabilities.
• Significance: A general indicator of short-term solvency. A standard benchmark is 2:1. If the ratio is too high, it may indicate that too much capital is tied up in idle assets like cash or excessive inventory.

1.2.2 Liquid (Acid Test) Ratio

• Formula: (Current Assets − Inventory) ÷ Current Liabilities.
• Significance: A more rigorous test of liquidity because it excludes inventory, which is the asset that takes the longest to turn into cash. A standard benchmark is 1:1. A ratio below this indicates the business may struggle to pay immediate debts.

03 Efficiency Ratios

These measure how effectively the business manages its working capital components.

1.3.1 Rate of Inventory Turnover (Times)

• Formula (times): Cost of Sales ÷ Average Inventory.
• Note: Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2.
• Significance: Measures how many times a firm sells and replaces its inventory during a period. A high turnover is generally better as it indicates strong sales and less risk of inventory becoming obsolete.

1.3.1b Inventory Turnover (Days)

• Formula (days): (Average Inventory ÷ Cost of Sales) × 365.
• Significance: Shows the average number of days inventory is held before being sold. A lower figure indicates faster-moving stock and better working capital management.
• Worked Example: Opening inventory $8,000; closing inventory $12,000; cost of sales $120,000.
  Average inventory = (8,000 + 12,000) ÷ 2 = $10,000
  Turnover (times) = 120,000 ÷ 10,000 = 12 times
  Turnover (days) = (10,000 ÷ 120,000) × 365 = 30.4 days (approx. 30 days)

1.3.2 Trade Receivables Turnover (Days)

• Formula: (Trade Receivables ÷ Credit Sales) × 365.
• Significance: Measures the average number of days it takes for credit customers to pay. Businesses aim for a low number to ensure cash is available for operations.

1.3.3 Trade Payables Turnover (Days)

• Formula: (Trade Payables ÷ Credit Purchases) × 365.
• Significance: Measures the average time the business takes to pay its suppliers. While delaying payment can help liquidity, it may result in lost discounts or damaged supplier relations.
• Worked Example: Trade payables $9,125; credit purchases $73,000.
  Calculation: (9,125 ÷ 73,000) × 365 = 45.6 days (approx. 46 days)

04 Official Syllabus Ratio Summary

The Cambridge 0452 syllabus provides the only formulas accepted in candidate responses. Memorise this table: