Cambridge IGCSE0452

Calculation and understanding of accounting ratios

Accounting 0452 Chapter Notes

What this chapter covers

Calculation and understanding of accounting ratiosInterpretation of accounting ratiosInter-business comparisonInterested partiesLimitations of accounting statements
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In this chapter

  1. 1Profitability Ratios: Gross and Profit Margins
  2. 2Profitability Ratios: Return on Capital Employed (ROCE)
  3. 3Liquidity Ratios: Current and Liquid (Acid Test) Ratios
  4. 4Efficiency Ratios: Rate of Inventory Turnover
  5. 5Efficiency Ratios: Trade Receivables and Payables Turnover

1. Profitability Ratios: Gross and Profit Margins

Profitability ratios measure a business's ability to generate profit from its sales. The Gross Profit Margin shows the profit made from the basic trading activity of buying and selling goods. It reveals how much profit is made on every £1 of revenue before deducting overheads. The Profit Margin (or Net Profit Margin) is a more comprehensive measure, showing the final profit after all expenses, including operating costs, have been deducted. A large difference between the two margins indicates high overhead expenses.

Gross Profit Margin (%) = (Gross Profit / Revenue) x 100

Profit Margin (%) = (Profit for the Year / Revenue) x 100

Key term

Profitability: A measure of a business's ability to generate profit from its sales or resources over a period of time.

Examiner insight

Examiners award higher marks for answers that explain the relationship between the two margins, for instance, by identifying that high overheads are responsible for a large drop from gross to net profit margin.

Common pitfall

Using profit for the year to calculate the gross profit margin. Always remember to use gross profit for this calculation.

Worked example 14 marks

The following data is from the Income Statement of ABC Ltd for the year ended 31 December 2023: Revenue: $200,000 Cost of Sales: $120,000 Expenses: $50,000 Calculate the Gross Profit Margin and the Profit Margin.

  1. 1
    1. Calculate Gross Profit: Revenue - Cost of Sales = $200,000 - $120,000 = $80,000.
  2. 2
    1. Calculate Gross Profit Margin: (Gross Profit / Revenue) x 100 = ($80,000 / $200,000) x 100 = 40%.
  3. 3
    1. Calculate Profit for the Year: Gross Profit - Expenses = $80,000 - $50,000 = $30,000.
  4. 4
    1. Calculate Profit Margin: (Profit for the Year / Revenue) x 100 = ($30,000 / $200,000) x 100 = 15%.

Recap

  • Gross profit margin measures trading profitability.
  • Profit margin measures overall profitability after all expenses.
  • Both ratios are expressed as a percentage of revenue.
  • A falling profit margin with a stable gross margin suggests poor control over expenses.
  • These ratios are used to compare performance between different years or with competitors.

Quick check

  1. If a business has a gross profit margin of 60% and a profit margin of 10%, what does this suggest?2 marks

2. Profitability Ratios: Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE) is considered a primary measure of profitability. It shows how effectively a business is using its long-term funds to generate profit. It calculates the profit generated as a percentage of the capital invested in the business. A higher ROCE is desirable, as it indicates greater efficiency in using capital. It's often compared with the interest rates on borrowing to see if the investment is worthwhile.

ROCE (%) = (Profit from Operations / Capital Employed) x 100

Capital Employed = Total Assets - Current Liabilities

OR Capital Employed = Equity + Non-Current Liabilities

Key term

Capital Employed: The total long-term funds invested in the business from both owners (equity) and lenders (non-current liabilities).

Examiner insight

Demonstrate a deeper understanding by comparing the calculated ROCE with a hypothetical bank interest rate. For example, 'A ROCE of 13.33% is a good return, as it is significantly higher than the 5% interest that could be earned in a bank.'

Common pitfall

Using 'Profit for the Year' instead of 'Profit from Operations'. The profit figure must be taken before deducting interest, as capital employed includes the loans on which interest is paid.

Worked example 13 marks

A business has the following figures: Profit from Operations: $60,000 Total Assets: $550,000 Non-Current Liabilities: $150,000 Current Liabilities: $100,000 Calculate the Return on Capital Employed (ROCE).

  1. 1
    1. Calculate Capital Employed: Total Assets - Current Liabilities = $550,000 - $100,000 = $450,000.
  2. 2
    1. (Alternative Capital Employed calculation to check: Equity would be $300,000 ($550k - $150k - $100k). Equity + NCL = $300,000 + $150,000 = $450,000).
  3. 3
    1. Calculate ROCE: (Profit from Operations / Capital Employed) x 100 = ($60,000 / $450,000) x 100.
  4. 4
    1. Final Answer: ROCE = 13.33%.

Recap

  • ROCE measures how efficiently a business uses its capital to generate profit.
  • A higher ROCE indicates better performance.
  • Capital employed represents the long-term funds used by the business.
  • The profit figure used is 'Profit from Operations', before interest and tax.
  • ROCE should be compared to previous years and interest rates on borrowing.

Quick check

  1. State the two main components needed to calculate ROCE.2 marks
  2. Why is ROCE considered a better measure of performance than the absolute profit figure?2 marks

3. Liquidity Ratios: Current and Liquid (Acid Test) Ratios

Liquidity ratios assess a business's ability to pay its short-term debts (current liabilities) as they fall due. The Current Ratio compares all current assets with all current liabilities. A commonly accepted ideal is between 1.5:1 and 2:1. The Liquid Ratio (also known as the Acid Test Ratio) is a stricter test. It removes inventory from current assets on the basis that inventory may not be easily or quickly converted into cash. An ideal liquid ratio is typically around 1:1.

Current Ratio = Current Assets / Current Liabilities

Liquid (Acid Test) Ratio = (Current Assets - Inventory) / Current Liabilities

Key term

Liquidity: The ability of a business to meet its short-term financial obligations (debts due within one year).

Common pitfall

Expressing the answer as a single number or percentage instead of a ratio format (e.g., writing '1.8' instead of '1.8:1').

Fun fact

Supermarkets often have a current ratio below 1 because they sell goods for cash very quickly but get long credit periods from their suppliers, effectively using suppliers' money to fund their operations.

Worked example 14 marks

From the Statement of Financial Position of Z Corp: Current Assets: Inventory: $50,000 Trade Receivables: $30,000 Cash: $10,000 Current Liabilities: Trade Payables: $40,000 Bank Overdraft: $10,000 Calculate the current ratio and the liquid (acid test) ratio.

  1. 1
    1. Calculate Total Current Assets: $50,000 (Inventory) + $30,000 (Receivables) + $10,000 (Cash) = $90,000.
  2. 2
    1. Calculate Total Current Liabilities: $40,000 (Payables) + $10,000 (Overdraft) = $50,000.
  3. 3
    1. Calculate Current Ratio: Current Assets / Current Liabilities = $90,000 / $50,000 = 1.8:1.
  4. 4
    1. Calculate Liquid Assets (Current Assets - Inventory): $90,000 - $50,000 = $40,000.
  5. 5
    1. Calculate Liquid Ratio: Liquid Assets / Current Liabilities = $40,000 / $50,000 = 0.8:1.

Recap

  • Liquidity ratios measure the ability to pay short-term debts.
  • The current ratio compares current assets to current liabilities.
  • The liquid ratio is a stricter test that excludes inventory from current assets.
  • Answers for liquidity ratios are expressed as a ratio to 1, for example, 1.8:1.
  • A ratio below 1:1 suggests potential short-term cash flow problems.

Quick check

  1. Which asset is excluded from the liquid ratio calculation and why?2 marks

4. Efficiency Ratios: Rate of Inventory Turnover

Efficiency ratios measure how well a business uses its assets and liabilities. The Rate of Inventory Turnover measures how quickly a company sells its inventory. It can be calculated in two ways: as 'times per year' or 'days'. A higher number of 'times' or a lower number of 'days' is generally better, as it means the business is not tying up cash in slow-moving inventory. However, the ideal rate varies significantly by industry (e.g., a fresh fruit seller vs. a jeweller).

Rate of Inventory Turnover (times) = Cost of Sales / Average Inventory

Rate of Inventory Turnover (days) = (Average Inventory / Cost of Sales) x 365

Average Inventory = (Opening Inventory + Closing Inventory) / 2

Key term

Inventory Turnover: A measure of the number of times inventory is sold or used in a time period, indicating the liquidity of inventory.

Examiner insight

Top-level answers will place the result in context. For example, 'An inventory turnover of 36.5 days is excellent for a supermarket but would be very poor for a company selling large machinery.'

Common pitfall

Using Revenue instead of Cost of Sales. Inventory is valued at cost, so it must be compared with the cost of the goods sold, not their selling price.

Worked example 14 marks

A business provides the following data: Cost of Sales: $450,000 Opening Inventory: $40,000 Closing Inventory: $50,000 Calculate the rate of inventory turnover in times and in days.

  1. 1
    1. Calculate Average Inventory: (Opening Inventory + Closing Inventory) / 2 = ($40,000 + $50,000) / 2 = $45,000.
  2. 2
    1. Calculate Turnover in Times: Cost of Sales / Average Inventory = $450,000 / $45,000 = 10 times.
  3. 3
    1. Calculate Turnover in Days: (Average Inventory / Cost of Sales) x 365 = ($45,000 / $450,000) x 365 = 36.5 days.
  4. 4
    1. Interpretation: The business sells its entire inventory, on average, 10 times a year, or every 36.5 days.

Recap

  • Inventory turnover measures how efficiently inventory is managed.
  • A high turnover rate is usually desirable.
  • The formula uses Cost of Sales, not Revenue.
  • Average inventory gives a more balanced view than just using closing inventory.
  • The ideal turnover rate is highly dependent on the industry type.

Quick check

  1. If opening inventory is not given, what figure should you use to calculate the ratio?1 mark

5. Efficiency Ratios: Trade Receivables and Payables Turnover

These ratios are key indicators of how well a business manages its working capital. The Trade Receivables Turnover (in days) shows the average number of days it takes for a business to collect money from its credit customers. A lower number of days is better. The Trade Payables Turnover (in days) shows the average number of days it takes for a business to pay its credit suppliers. A higher number of days is generally better, as it means the business is holding onto its cash for longer. Ideally, a business should collect cash from receivables faster than it pays its payables.

Trade Receivables Turnover (days) = (Trade Receivables / Credit Sales) x 365

Trade Payables Turnover (days) = (Trade Payables / Credit Purchases) x 365

Key term

Working Capital Cycle: The time lag between paying for raw materials and receiving cash from the sale of finished goods.

Examiner insight

Marks are often awarded for comparing the two ratios. A student who simply calculates the figures will score less than a student who calculates them and then explains the relationship, e.g., 'The company's cash flow is positive in this regard as it receives cash (30 days) before it has to pay its own suppliers (49 days).'

Common pitfall

Using total sales or total purchases when the question provides credit sales/purchases. These ratios are specifically about the management of credit.

Worked example 15 marks

Data for FastTrack plc: Trade Receivables: $50,000 Credit Sales: $600,000 Trade Payables: $40,000 Credit Purchases: $300,000 Calculate the trade receivables and trade payables turnover in days.

  1. 1
    1. Calculate Trade Receivables Turnover (days): (Trade Receivables / Credit Sales) x 365 = ($50,000 / $600,000) x 365 = 30.4 days.
  2. 2
    1. Round to a sensible figure: approximately 30 days.
  3. 3
    1. Calculate Trade Payables Turnover (days): (Trade Payables / Credit Purchases) x 365 = ($40,000 / $300,000) x 365 = 48.7 days.
  4. 4
    1. Round to a sensible figure: approximately 49 days.
  5. 5
    1. Comment: The business takes 49 days to pay its suppliers but collects cash from customers in 30 days. This is a healthy position for cash flow.

Recap

  • Receivables turnover shows how long customers take to pay.
  • Payables turnover shows how long the business takes to pay suppliers.
  • For receivables, fewer days is better.
  • For payables, more days is generally better (without damaging supplier relationships).
  • Always use credit sales and credit purchases, not total figures.
  • Comparing the two ratios reveals the impact on the business's cash flow.

Quick check

  1. What problem might a business face if its receivables turnover is 90 days and its payables turnover is 30 days?2 marks

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. A business has current assets of $50,000 and a current ratio of 2.5:1. Calculate its current liabilities.2 marks
  2. Revenue is $500,000 and the profit margin is 12%. Calculate the profit for the year.2 marks
  3. A company's cost of sales is $300,000 and its average inventory is $50,000. Calculate the rate of inventory turnover in times.2 marks
  4. Given the following: Current Assets $120,000; Inventory $40,000; Current Liabilities $80,000. Calculate the current ratio and the liquid (acid test) ratio.4 marks
  5. A business has a gross profit of $90,000 and revenue of $300,000. Its profit for the year is $30,000. Calculate the gross profit margin and the profit margin.4 marks
  6. The trade receivables of a firm are $60,000 and its credit sales for the year were $730,000. Calculate the trade receivables turnover period in days.3 marks
  7. The ROCE of a business fell from 20% to 15% this year. Suggest two different reasons for this fall.4 marks
  8. A business has a current ratio of 0.9:1. Explain what this means and suggest two actions the business could take to improve it.5 marks
  9. The following figures relate to two businesses in the same industry. Business A: Gross Margin 50%, Profit Margin 5%. Business B: Gross Margin 30%, Profit Margin 15%. Analyse and compare the performance of the two businesses.6 marks
  10. A company's financial statements show: Profit from Operations $100,000; Equity $400,000; Non-Current Liabilities $200,000; Current Liabilities $150,000. Last year, the ROCE was 20%. Calculate this year's ROCE and comment on the change in performance.6 marks

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