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Financial Ratio Analysis

Ratio Analysis Focus Areas

1

Liquidity Ratios

Ability to meet short-term obligations (Current & Acid Test).
2

Profitability Ratios

Effectiveness in generating profits (Margins, ROCE, ROE).
3

Evaluation & Usefulness

Contextual interpretation and stakeholder value.

Introduction to Ratio Analysis

Purpose of Ratios

Ratio analysis involves calculating numerical relationships between different items from financial statements to assess a business’s financial health, efficiency, and profitability. Ratios simplify complex financial information and facilitate comparison over time or with other businesses.

Calculating Liquidity Ratios

Liquidity ratios indicate a company’s ability to meet short-term obligations.

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Current Ratio

Ability to cover short-term debts with short-term assets.
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Acid Test (Quick)

A stricter measure, excluding inventory because it may not be quickly converted to cash.

Current Ratio Formula

Current Assets ÷ Current Liabilities
This ratio measures the ability to cover short-term debts with short-term assets. A ratio of around 1.5 to 2 is typically seen as healthy.

Acid Test Ratio Key

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Acid Test (Quick) Ratio Formula: (Current Assets – Inventory) ÷ Current Liabilities. An acid test ratio of 1 or higher generally signifies good liquidity.

Core Profitability Ratios

Profitability ratios show how effectively a business generates profits from its sales or capital.

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Gross Profit Margin

Percentage of revenue remaining after direct costs. High margin means effective production cost management.
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Return On Equity (ROE)

Shows how well shareholders’ funds are used to generate profit. Higher ROE indicates better returns for investors.
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ROCE

Measures efficiency in generating profits from invested capital (Equity + Non-Current Liabilities).

Net Profit Margin Formula

(Net Profit ÷ Revenue) × 100
Indicates overall profitability after all expenses, showing how much profit is earned from each pound of sales.

Evaluating Financial Position

Interpreting ratios together reveals the overall financial health.

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The profitability ratios are strong, does this guarantee survival?
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Not alone. A company might have good profitability but weak liquidity, highlighting potential cash flow issues.

Usefulness & Limitations

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The Pros (Usefulness)For management: Enables quick assessment of financial performance and operational areas requiring attention. For investors/creditors: Helps judge profitability and credit risk.
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The Cons (Limitations)Ratios rely on accurate financial reporting; Industry differences must be considered; Ratios show what has happened historically but cannot predict future events.
Financial Ratio Analysis Deck
Term
Financial Ratio Analysis

What is financial ratio analysis?

Answer
Definition

Calculating relationships between financial statement items to assess a business's health, efficiency, and profitability.

Term
Current Ratio

What does the current ratio measure?

Answer
Definition

Ability to cover short-term debts with short-term assets.

Term
Current Ratio Formula

Formula for the current ratio?

Answer
Formula

Current Assets ÷ Current Liabilities.

Term
Current Ratio Below 1

What does a current ratio below 1 suggest?

Answer
Implication

Potential liquidity problems.

Term
Acid Test Ratio

What is the acid test (quick) ratio?

Answer
Definition

A stricter liquidity measure excluding inventory.

Term
Acid Test Ratio Formula

Formula for the acid test ratio?

Answer
Formula

(Current Assets – Inventory) ÷ Current Liabilities.

Term
Gross Profit Margin

What does a gross profit margin show?

Answer
Definition

Percentage of revenue remaining after direct production costs.

Term
Gross Profit Margin Formula

Formula for gross profit margin?

Answer
Formula

(Gross Profit ÷ Revenue) × 100.

Term
Net Profit Margin

What is net profit margin?

Answer
Definition

Profitability after all expenses, showing profit per sales unit.

Term
Net Profit Margin Formula

Formula for net profit margin?

Answer
Formula

(Net Profit ÷ Revenue) × 100.

Term
Return on Capital Employed (ROCE)

What does return on capital employed (ROCE) indicate?

Answer
Definition

Efficiency in generating profits from invested capital.

Term
ROCE Formula

Formula for ROCE?

Answer
Formula

(Operating Profit ÷ Capital Employed) × 100.

Term
Return on Equity (ROE)

What is return on equity (ROE)?

Answer
Definition

How well shareholders’ funds generate profit.

Term
ROE Formula

Formula for ROE?

Answer
Formula

(Net Profit ÷ Shareholders’ Equity) × 100.

Term
Ratio Comparison

Why compare ratios over time and with competitors?

Answer
Purpose

To identify trends and relative performance.

Term
Limitations

Name a limitation of ratio analysis.

Answer
Limitation

Ratios rely on accurate financial reports and don’t predict future events.

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📊 Financial Ratio Analysis Quiz

1. What does the current ratio assess?

The current ratio compares current assets to current liabilities to measure liquidity.

2. Which of the following formulas represents the acid test ratio?

The acid test ratio excludes inventory for a stricter liquidity measure.

3. A high gross profit margin indicates:

Gross profit margin shows percentage of revenue remaining after direct costs.

4. Return on equity (ROE) measures:

ROE indicates how well equity funds are used for profit.

5. Which of these is a limitation of financial ratio analysis?

Ratios can mislead if financial statements are inaccurate.

📊 Results

  • Notes and Quiz
  • Business
  • AS Level
  • Accounting & Finance
  • OCR