IGCSE Accounting (0452) Study Notes: Calculation and Understanding of Accounting Ratios

Welcome to the most practical and exciting chapter of IGCSE Accounting: Analysis and Interpretation! You have spent all this time preparing financial statements (Income Statements and Statements of Financial Position). Now, we learn how to use these complex documents to tell a simple, clear story about the business's health.

What is an Accounting Ratio?

Think of accounting ratios like a quick medical check-up for a business. A doctor doesn't just look at your raw weight and height; they calculate your BMI (a ratio) and check your heart rate (another ratio). Similarly, ratios compare two related figures from the financial statements to give us instant insight into performance and position.

Why are Ratios Important?

  • They simplify complex data, making comparison easy.
  • They help managers make better decisions (e.g., should we borrow more?).
  • They allow comparison:
    • Internal Comparison: Comparing this year's results with last year's.
    • Inter-Firm Comparison: Comparing our business with a competitor (although this has limitations, as we will discuss later!).

1. Profitability Ratios: How Efficiently Does the Business Make Money?

Profitability ratios measure the success of the business operations. The higher these ratios are, generally, the better!

1.1 Gross Margin (Gross Profit / Revenue)

The Gross Margin tells us the percentage of revenue (sales) that remains after paying for the goods sold (Cost of Sales). It measures how well the business controls the cost of its inventory.

Formula:

\[ \text{Gross Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \]

Example: If the Gross Margin is 40%, it means that for every \$100 of goods sold, \$40 is Gross Profit, and \$60 was the Cost of Sales.

1.2 Mark Up (Gross Profit / Cost of Sales)

Mark up is closely related to Gross Margin, but it is calculated as a percentage of the Cost of Sales (the cost price), not the selling price (Revenue).

Formula:

\[ \text{Mark up} = \frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100 \]

Quick Review: Margin vs. Mark Up

  • If a business buys an item for \$80 (Cost of Sales) and sells it for \$100 (Revenue), the Gross Profit is \$20.
  • Margin: \(\frac{20}{100} \times 100 = 20\%\) (Profit is 20% of the Selling Price)
  • Mark up: \(\frac{20}{80} \times 100 = 25\%\) (Profit is 25% of the Cost Price)

1.3 Profit Margin (Profit for the year / Revenue)

The Profit Margin (often called the Net Profit Margin) tells us the percentage of revenue that remains after paying for all operating expenses (wages, rent, utilities, etc.), not just the cost of goods sold. This shows the overall efficiency of the business.

Formula:

\[ \text{Profit Margin} = \frac{\text{Profit for the year}}{\text{Revenue}} \times 100 \]

Importance: A high Profit Margin indicates excellent control over operating expenses.

Did you know? Understanding the difference between Gross Margin and Profit Margin is crucial. If Gross Margin is high but Profit Margin is low, it means the business is making good money on sales, but its running costs (expenses) are too high!

1.4 Return on Capital Employed (ROCE)

ROCE is arguably the most important profitability ratio. It measures how effectively the business is using the long-term funds invested in it (the 'Capital Employed') to generate profit.

Formula:

\[ \text{ROCE} = \frac{\text{Net profit before interest}}{\text{Capital employed}} \times 100 \]

Key Definition: Capital Employed

The capital employed represents the long-term money available to the business. According to the syllabus, this is calculated as:

\[ \text{Capital Employed} = \text{Issued Shares} + \text{Reserves} + \text{Non-Current Liabilities} \]

Interpretation: If the ROCE is 15%, it means the business is generating 15 cents of profit (before interest) for every \$1 of long-term capital invested. A business should aim for an ROCE higher than the bank interest rate, otherwise, the owners would be better off just putting their money in the bank!

Key Takeaway: Profitability Ratios

These ratios assess how successful the business is at generating returns. ROCE is the ultimate measure of investment efficiency.

2. Liquidity Ratios: Can the Business Pay Its Debts?

Liquidity refers to a business’s ability to meet its short-term financial obligations (debts due within one year). These ratios are vital for managers and banks.

2.1 Current Ratio (Working Capital Ratio)

This ratio compares the assets that can be converted to cash quickly (Current Assets) with the debts that must be paid quickly (Current Liabilities).

Formula:

\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]

The answer is usually expressed as a ratio, e.g., 2:1.

Interpretation:

  • A ratio of 2:1 means the business has \$2 of Current Assets for every \$1 of Current Liabilities. This is usually considered healthy.
  • If the ratio is too low (e.g., 0.8:1), the business may struggle to pay its immediate debts (a liquidity crisis).
  • If the ratio is too high (e.g., 5:1), the business might not be using its cash effectively (too much money tied up in inventory or idle bank accounts).

2.2 Liquid (Acid Test) Ratio (Quick Ratio)

The Acid Test Ratio is a stricter measure of immediate liquidity. It excludes Inventory (stock) from Current Assets because inventory can sometimes be difficult or slow to sell, especially if it is perishable or specialized.

Formula:

\[ \text{Liquid (Acid Test) Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \]

Interpretation:

  • A ratio of 1:1 is often considered satisfactory. This means the business has enough immediately usable assets (cash and receivables) to cover its immediate debts.
  • If the Current Ratio is high (say, 3:1) but the Acid Test Ratio is very low (say, 0.5:1), it suggests that the business is relying too heavily on selling its stock to pay its bills. If sales slow down, the business is in trouble.

Key Takeaway: Liquidity Ratios

These ratios check short-term financial safety. The Current Ratio gives a broad view; the Liquid (Acid Test) Ratio gives a view of immediate cash-paying ability.

3. Efficiency Ratios: How Effectively Are Assets Managed?

Efficiency ratios measure how well the business manages its key operational assets, such as inventory and trade receivables.

3.1 Rate of Inventory Turnover

This ratio measures how quickly, on average, the business sells and replaces its inventory over a period. A high turnover is usually desirable as it means inventory is not sitting around getting old or obsolete.

Formula:

\[ \text{Rate of Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} \]

The answer is given in times (e.g., 10 times).

Prerequisite Concept: Average Inventory

Since the Cost of Goods Sold covers the whole year, we should use the average stock level during that year, not just the closing stock.

\[ \text{Average Inventory} = \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2} \]

Interpretation: A higher number of times (e.g., 12 times a year) means the business is selling inventory faster. This is good, but if it is too high, the business might suffer from stockouts (running out of popular items).

3.2 Trade Receivables Turnover (Debtors Collection Period)

This ratio calculates the average time it takes for customers (Trade Receivables) who bought goods on credit to pay the business.

Formula:

\[ \text{Trade Receivables Turnover} = \frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365 \]

The answer is given in days.

Interpretation:

  • A lower number of days is better, as cash is received faster.
  • If the average collection period is 60 days, but the business's policy is to offer 30 days credit, this means customers are paying late, potentially leading to cash flow problems.

3.3 Trade Payables Turnover (Creditors Payment Period)

This ratio calculates the average time the business takes to pay its own suppliers (Trade Payables).

Formula:

\[ \text{Trade Payables Turnover} = \frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365 \]

The answer is given in days.

Interpretation:

  • Businesses want to delay payment as long as possible (to take advantage of "free" credit) without annoying their suppliers.
  • If the payment period is too long, the business risks damaging its reputation, losing discounts, or facing legal action.

Key Takeaway: Efficiency Ratios

These ratios demonstrate how well the management utilizes assets to generate sales and manage working capital. They focus on the speed of operations (inventory movement, paying, and being paid).

Review Table of All Required Ratios (0452)

4.1 Profitability

RatioFormulaMeasures
Gross Margin\(\frac{\text{Gross Profit}}{\text{Revenue}} \times 100\)Profitability before expenses.
Mark up\(\frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100\)Profit as a percentage of cost.
Profit Margin\(\frac{\text{Profit for the year}}{\text{Revenue}} \times 100\)Overall business efficiency.
ROCE\(\frac{\text{Net profit before interest}}{\text{Capital employed}} \times 100\)Return on long-term investment.

4.2 Liquidity

RatioFormulaMeasures
Current Ratio\(\frac{\text{Current Assets}}{\text{Current Liabilities}}\)Ability to pay short-term debts (general).
Liquid (Acid Test) Ratio\(\frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}\)Ability to pay immediate debts (strict).

4.3 Efficiency/Turnover

RatioFormulaMeasures
Rate of Inventory Turnover\(\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}\)Speed of stock replacement (times per year).
Trade Receivables Turnover\(\frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365\)Average time taken by customers to pay (days).
Trade Payables Turnover\(\frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365\)Average time taken to pay suppliers (days).

Don't worry if all these formulas seem overwhelming at first! Practice is key. Remember the categories (Profit, Cash, Speed) and what each ratio is trying to tell you about the business. You can do this!