Ratio analysis helps stakeholders judge how well a business is performing using numbers from its financial statements. In A Level Business, you are expected to calculate ratios, interpret them and evaluate the limits of the results. This guide covers the main liquidity and profitability ratios with a worked example.
Why Use Ratios?
Ratios turn raw figures into comparisons. They allow you to compare a business with its past results, with competitors and with targets, which is more useful than looking at the figures alone.
Profitability Ratios
- Gross profit margin = (gross profit / revenue) x 100
- Net profit margin = (net profit / revenue) x 100
- ROCE = (operating profit / capital employed) x 100
Higher margins mean the business keeps more of each rupee of sales as profit. ROCE shows how efficiently capital is used.
Liquidity Ratios
- Current ratio = current assets / current liabilities
- Acid test ratio = (current assets – inventory) / current liabilities
These show whether a business can pay its short-term debts. A current ratio between roughly 1.5 and 2 is often seen as comfortable, but the ideal level depends on the industry.
Worked Example (Rs)
| Item | Amount |
|---|---|
| Revenue | 1,000,000 |
| Gross profit | 400,000 |
| Net profit | 100,000 |
| Current assets | 300,000 |
| Inventory | 120,000 |
| Current liabilities | 200,000 |
- Gross profit margin = 400,000 / 1,000,000 x 100 = 40%
- Net profit margin = 100,000 / 1,000,000 x 100 = 10%
- Current ratio = 300,000 / 200,000 = 1.5
- Acid test = (300,000 – 120,000) / 200,000 = 0.9
How to Interpret Ratios
An acid test ratio below 1 means the business may struggle to pay short-term debts without selling inventory. A falling net margin while gross margin stays steady suggests rising overheads.
Limitations of Ratio Analysis
- Based on past data, not future performance.
- Different industries have different normal ratios.
- Accounting methods can affect the numbers.
- Ratios ignore non-financial factors such as staff morale or brand strength.
Exam Tips
Show the formula and working, state what the result means, then add a judgement. Compare with another year or business whenever data is provided. Related reading: cash flow forecast vs profit.
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Frequently Asked Questions
What is the difference between liquidity and profitability ratios?
Liquidity ratios measure the ability to pay short-term debts. Profitability ratios measure how much profit a business earns from its sales or capital.
What is ROCE?
Return on capital employed shows operating profit as a percentage of capital employed, measuring how efficiently capital generates profit.
What is a good current ratio?
Often between about 1.5 and 2, but it depends on the industry and the business.
Are ratios in the O Level syllabus?
Basic profit margin ideas appear at O Level, while full liquidity and profitability analysis is mainly an A Level topic.
