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Topic 4 of 5 · Form 5 · Lower 6

Ratio analysis and interpretation

Based on historical data, affected by different accounting policies and inflation, may be distorted at the year end, and ignore non-financial factors.

Notes for this topic 1 file, in order

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  1. PDFRatio analysis and interpretation – Accounting notes (ZIMSEC A Level)47.6 KB

Profitability

  • Gross margin = gross profit ÷ revenue × 100.
  • Profit margin = profit for the year ÷ revenue × 100.
  • Return on capital employed (ROCE) = profit before interest and tax ÷ capital employed × 100 (capital employed = equity + non-current liabilities).

Liquidity

  • Current ratio = current assets ÷ current liabilities (about 1.5–2 is often considered healthy).
  • Liquid (acid test) ratio = (current assets − inventory) ÷ current liabilities.

Efficiency

  • Inventory turnover = cost of sales ÷ average inventory (times per year).
  • Trade receivables collection period = trade receivables ÷ credit sales × 365 days.
  • Trade payables payment period = trade payables ÷ credit purchases × 365 days.

Gearing and investment

  • Gearing = non-current liabilities ÷ capital employed × 100. High gearing means higher risk.
  • Earnings per share = profit attributable to ordinary shareholders ÷ number of ordinary shares.
  • Price/earnings ratio = market price ÷ EPS. Dividend yield = dividend per share ÷ market price × 100.

Worked example: Current assets US$90 000 (inventory US$40 000); current liabilities US$50 000. Find the current and liquid ratios.

Current ratio = 90 000 ÷ 50 000 = 1.8 : 1

Liquid ratio = 50 000 ÷ 50 000 = 1.0 : 1

Limitations

Based on historical data, affected by different accounting policies and inflation, may be distorted at the year end, and ignore non-financial factors.

Exam tip: Always interpret a ratio – compare it with last year, a competitor or the industry, and give a reason for the change.

Check yourself

  1. Revenue US$200 000; gross profit US$70 000. Find the gross margin.
  2. Receivables US$30 000; credit sales US$365 000. Find the collection period.
  3. What does high gearing indicate?
Show answers
  1. 35%
  2. 30 days
  3. The business relies heavily on borrowed funds, increasing risk and interest commitments.
Next topicManufacturing accounts and inventory valuation

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