Ratios in ACCA Financial Accounting: Chapter Guide

What this chapter covers

Ratios: topics in the order to study them

1. 1Purpose and Limitations of Ratio AnalysisStart here to learn what ratios are for, who uses them and why they must be compared with something, before you calculate anything.
2. 2Profitability RatiosThese use the statement of profit or loss, which you already know well, so they are the easiest first set of formulas.
3. 3Liquidity RatiosThey bring in the statement of financial position and introduce current assets and current liabilities.
4. 4Efficiency Ratios and Working Capital CycleYou need the liquidity ideas first, because these ratios explain why liquidity looks the way it does.
5. 5Investor RatiosThese use share data and dividends, and they are a short, separate set of formulas once the core ratios are secure.
6. 6Gearing RatiosThey look at long-term finance and interest cover, which builds on profit and statement of financial position knowledge.
7. 7Interpreting Ratios and Writing a ReportFinish with interpretation, because it needs every ratio group and tests whether you can explain what the numbers mean.

How to prepare Ratios

1. Write a one-page formula sheet as you study each topic. Include the numerator, the denominator and the unit (%, times or days).
2. Learn where each figure comes from. Ask yourself: which statement, which line, which period?
3. Do a few calculations by hand for each ratio. Use a small set of accounts and compute every ratio from it.
4. Practise short comments. For each ratio, write one sentence on what a rise or fall could mean, and give at least two possible causes.
5. Drill objective questions in timed sets. Practise multiple choice, multiple response and number entry, and check the rounding and units asked for.
6. Work a full interpretation: two years of figures, all ratios, then a short report with findings and a conclusion.
7. Revise the formula sheet the day before the exam and test yourself by writing it from memory.

Common mistakes in Ratios

• Using the wrong profit figure in a ratio.

  Fix: Link each ratio to its profit measure on your formula sheet and underline the profit line in the question before you calculate.

• Using revenue instead of cost of sales (or credit purchases) for inventory and payables days.

  Fix: Remember: inventory and payables days use cost of sales or purchases, receivables days use credit sales. Use revenue for receivables if credit sales are not given.

• Mixing up capital employed and equity in ratios.

  Fix: Write the definition down: capital employed = equity + non-current liabilities. Check the question's definition each time.

• Giving the number but no meaning.

  Fix: For every ratio, add what the change suggests, such as better cost control, slower collection or more borrowing. Offer more than one possible cause.

• Ignoring units, rounding and the direction of change in number entry questions.

  Fix: Re-read the final line of the question. Check whether it wants days, percent or times, and the decimal places needed.

• Treating a high or low ratio as automatically good or bad.

  Fix: Judge each ratio against the business type, past results and other ratios. A high current ratio, for example, could mean idle cash or slow-moving inventory.

Last-day revision: Ratios

• ✓Ratios are only useful when compared with prior years, other businesses or industry averages.
• ✓Gross profit margin = gross profit ÷ revenue × 100.
• ✓Operating profit margin = profit from operations ÷ revenue × 100.
• ✓Current ratio = current assets ÷ current liabilities; quick ratio = (current assets − inventory) ÷ current liabilities.
• ✓Inventory days = inventory ÷ cost of sales × 365; receivables days = trade receivables ÷ credit sales × 365; payables days = trade payables ÷ credit purchases × 365.
• ✓Working capital cycle = inventory days + receivables days − payables days.
• ✓Earnings per share = profit attributable to ordinary shareholders ÷ number of ordinary shares; P/E = market price per share ÷ EPS.
• ✓Gearing is commonly debt ÷ equity or debt ÷ (debt + equity); use the definition the question gives.
• ✓Interest cover = profit before interest and tax ÷ finance costs.
• ✓Return on capital employed = profit before interest and tax ÷ (total assets − current liabilities) × 100.
• ✓Always check the unit, the rounding and whether the question asks for a percentage, times or days.
• ✓In a comment, state the change, give a likely reason and say what it means for the business.

Ratios practice questions

• Marlow Co had cost of sales of $730,000 for the year. Opening trade payables were $60,000 and closing trade payables were $100,000. Purchase…
• Delta Co has equity of $600,000 (including all reserves), a 6% loan note of $200,000 repayable in 2033 and a bank overdraft of $50,000. Usin…
• Which of the following best describes the main purpose of calculating ratios from a company's financial statements?
• Which of the following is a recognised limitation of using ratio analysis to assess the performance of a single company?
• Dunmore Co has 5,000,000 ordinary shares in issue. Profit after tax is $2,000,000 and the P/E ratio is 15. What is the market capitalisation…
• Zeta Co reported revenue of $800,000 and gross profit of $200,000 in the year just ended. Last year, revenue was $600,000 and gross profit w…
• When writing a report interpreting a company's ratios for a shareholder, which approach is most appropriate?
• Dunmore Co has cost of sales of $730,000, closing inventory of $120,000 and closing trade payables of $100,000. All purchases are on credit …

Ratios in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• Actuarial Core Principles (IAI)Interpreting company accounting information
• ACCA Applied SkillsCalculation and interpretation of accounting ratios and trends to address users' and stakeholders' needs
• CMA IntermediateFinancial Ratio Analysis
• CA IntermediateFinancial Analysis and Planning - Ratio Analysis