Calculate and interpret gross profit margin, net profit margin and ROCE
Calculate and interpret current ratio and acid test ratio
Calculate and interpret the gearing ratio
Calculate debtor and creditor days and inventory turnover
Evaluate ratios using trend analysis and industry benchmarking
Profitability
Profitability Ratios
Gross Profit Margin
GPM (%) = Gross Profit ÷ Revenue × 100
Measures how efficiently the firm converts sales into gross profit after direct costs. High GPM = strong pricing power or low COGS.
Net Profit Margin
NPM (%) = Net Profit ÷ Revenue × 100
Measures overall profitability after all costs including overheads. GPM − NPM gap = overhead burden.
ROCE
ROCE (%) = Operating Profit ÷ Capital Employed × 100
Capital Employed = Total Assets − Current Liabilities. Key investor metric — compare to cost of borrowing.
Return on Equity (ROE)
ROE (%) = Net Profit after Tax ÷ Shareholders' Equity × 100
Returns generated for shareholders — important for investor decisions; higher gearing inflates ROE (risk).
Example: GPM = 40%, NPM = 8%. The 32% gap represents overheads (distribution, marketing, admin). High overheads relative to gross profit is a warning sign.
Liquidity
Liquidity Ratios
Current Ratio
Current Assets ÷ Current Liabilities
Ideal: ~1.5:1 to 2:1. Too low = liquidity risk; too high = idle working capital. Manufacturing firms often run lower than retailers.
Acid Test Ratio
(Current Assets − Inventories) ÷ Current Liabilities
Ideal: ≥ 1:1. Excludes inventory (hardest to liquidate quickly). Critical measure of immediate liquidity. Below 1 = potential solvency risk.
Context matters: Supermarkets run very low acid tests (sell for cash, pay suppliers later) — not necessarily risky in their context
Financial Structure
Gearing Ratio
Formula
Gearing (%) = Non-Current Liabilities ÷ Capital Employed × 100
Capital Employed = Equity + Non-Current Liabilities
High Gearing (> 50%)
Large proportion of debt financing
Fixed interest payments regardless of profit
Risky when interest rates rise or profits fall
May deter risk-averse investors
Example: Highly leveraged private equity buyouts
Low Gearing (< 25%)
Mainly equity financed — safer
More flexible in downturns
May miss tax benefits of debt (interest is tax-deductible)
Shareholders bear all risk
Example: Cash-rich companies like Apple historically
Evaluation: High gearing is not inherently bad — if ROCE consistently exceeds the cost of debt, gearing magnifies returns to shareholders (financial leverage). The risk is that if profitability falls, interest obligations remain fixed.
Working Capital Efficiency
Efficiency Ratios
Inventory Turnover
Cost of Sales ÷ Average Inventory
Number of times stock is replaced per year. Higher = faster-moving stock (good). Compare to industry norm — a bakery turns over daily; a car dealer may take months.
Debtor Days
(Trade Receivables ÷ Revenue) × 365
Average days to collect payment from customers. Lower is better (faster cash collection). Rising debtor days = credit control problem.
Creditor Days
(Trade Payables ÷ Cost of Sales) × 365
Average days to pay suppliers. Longer = better for cash flow. But too long damages supplier relationships.
Asset Turnover
Revenue ÷ Total Assets
How efficiently assets generate revenue. Higher = more efficient use of asset base. Low = assets underutilised.
Analysis Framework
How to Interpret Ratios Properly
Trend analysis: Compare ratios over 3–5 years — a falling GPM signals rising COGS or falling prices; a rising gearing indicates growing debt burden
Industry benchmarking: Compare to sector averages — a 2% NPM is excellent in retail but poor in pharmaceuticals
Competitor comparison: Relative performance matters — improving ROCE while competitors improve faster still indicates falling competitiveness
Interconnection: A high inventory turnover improves cash flow; a low acid test may be offset by strong debtor management; ratios must be read together
A-Level evaluation: Ratios are backward-looking (historical data) and can be manipulated (e.g. sale-and-leaseback to reduce assets and boost ROCE). They provide no forward-looking insight and ignore qualitative factors like brand strength or market trends.
Critical Evaluation
Limitations of Ratio Analysis
Data Quality Issues
Based on historical financial statements — may not reflect current position
Different accounting policies across firms — FIFO vs LIFO inventory, depreciation methods
BGPM = 8%, NPM = 40%; good efficiency at controlling overheads
CGPM = 40%, NPM = 8%; overhead burden is small and efficient
DGPM = 32%, NPM = 8%; the gap represents cost of goods sold
A is correct. GPM = 320,000 ÷ 800,000 × 100 = 40%. NPM = 64,000 ÷ 800,000 × 100 = 8%. The 32% gap (GPM − NPM) represents overheads — distribution, salaries, marketing, admin. A 32-point overhead burden is substantial and warrants investigation into cost management.
Practice Question 2
A business has: Current Assets £240,000 (including Inventories £80,000); Current Liabilities £160,000. What is the acid test ratio and what does it indicate?
A1.5:1 — current ratio is healthy; no liquidity concerns
B1.0:1 — acid test is exactly 1; borderline but adequate immediate liquidity
C0.5:1 — acid test below 1; significant short-term liquidity risk
D2.0:1 — the business holds excessive liquid assets
B is correct. Acid Test = (Current Assets − Inventories) ÷ Current Liabilities = (240,000 − 80,000) ÷ 160,000 = 160,000 ÷ 160,000 = 1.0:1. Exactly 1:1 means the business can just cover its current liabilities from liquid assets — borderline acceptable. The current ratio (A) = 240,000 ÷ 160,000 = 1.5, not the question asked.
Practice Question 3
A firm has Non-Current Liabilities of £900,000 and Capital Employed of £2,000,000. Its gearing is 45%. The business wants to reduce gearing below 40%. Which strategy would achieve this?
AIssue more debt to fund expansion — this reduces the gearing ratio
BRetain profits (increasing equity) or repay long-term debt — both reduce gearing
CIncrease dividends to shareholders to strengthen the capital base
DSell current assets and convert them to fixed assets
B is correct. Gearing = NCL ÷ Capital Employed × 100 = 45%. To reduce gearing: either reduce NCL (repay debt) or increase Capital Employed by retaining profits (increasing equity). Issuing more debt (A) would increase NCL and worsen gearing. Increasing dividends (C) reduces retained profit, reducing equity — worsening gearing.
Summary
Key Takeaways
Profitability: GPM = gross efficiency; NPM = overall profit; ROCE = return on total investment; compare to cost of capital
Liquidity: Current ratio ~1.5–2:1; Acid test ≥1:1; below these = solvency risk
Gearing: >50% = high risk; manageable if ROCE > interest rate; reduce by retaining profits or repaying debt
Efficiency: Debtor days (lower better), creditor days (higher better for cash), inventory turnover (higher better)
Limitations: Historical, manipulable, no qualitative insight; must use trend + benchmark + context