HEXCO · Polytechnic · NC Accountancy

Business Accounting 2: Accounting Ratios

Learning Outcome 6 of 6

Free HEXCO NC Accountancy notes on Accounting Ratios, learning outcome 6 of 6 in Business Accounting 2. Correction of errors, control accounts, partnerships, incomplete records, manufacturing accounts and ratio analysis. Semester 2, module 310/22/M06.

Here we learn what financial ratios are, the main categories of profitability, liquidity and asset utilisation ratios, why ratio analysis is important, its limitations, and how to calculate and interpret ratios to assess a firm's performance.

A profit of $30,000 means little on its own, but comparing it with sales, capital or last year's figure shows whether the business is doing well, and ratios are the tools for making these comparisons.

6.1 Categories of Financial Ratios

A financial ratio is a relationship between two figures in the financial statements, expressed as a percentage, a proportion (such as 2:1), a number of times or a number of days.

Ratios are grouped into categories according to the aspect of the business they measure.

The Main Categories

Profitability ratios measure how well the business turns sales and capital into profit. Liquidity ratios measure the ability to pay short-term debts as they fall due. Asset utilisation (efficiency) ratios measure how efficiently assets such as inventory, receivables and non-current assets are used. Other categories, such as gearing ratios (long-term borrowing compared with capital) and investment ratios, are studied at higher levels.

The Data Used

The ratios in this outcome are calculated from the summarised figures of Zuva Wholesalers for 2025 shown below.

6.2 Calculating the Ratios

Each ratio is calculated with a set formula, and the answer is interpreted by comparing it with earlier years, other businesses or a target.

The worked examples use the data of Zuva Wholesalers.

Profitability Ratios

The gross profit margin shows how much gross profit is made on each dollar of sales, and depends on pricing and buying costs. The mark-up shows gross profit as a percentage of cost. The net profit margin shows the profit left after all expenses, so it reflects control of expenses. Return on capital employed (ROCE) shows the profit earned on the long-term funds invested, and is often called the primary ratio.

Here you are measuring how much profit the business makes from its sales and from the money invested in it. For each ratio, find the two figures in the statements, divide the top one by the bottom one, and multiply by 100 to get a percentage. Margins use revenue at the bottom, mark-up uses cost of sales, and ROCE uses capital employed. Below, we show you how it is done, step by step.

Calculate the profitability ratios.

Gross profit margin = gross profit ÷ revenue × 100 = 80,000 ÷ 200,000 × 100 = 40%
Mark-up = gross profit ÷ cost of sales × 100 = 80,000 ÷ 120,000 × 100 = 66.7%
Net profit margin = profit ÷ revenue × 100 = 30,000 ÷ 200,000 × 100 = 15%
ROCE = profit ÷ capital employed × 100 = 30,000 ÷ 150,000 × 100 = 20%

Answer: GP margin 40%; mark-up 66.7%; net margin 15%; ROCE 20%

Revenue $80,000; cost of sales $56,000; expenses $14,000; capital employed $50,000. Calculate the profitability ratios.

Gross profit = 80,000 − 56,000 = $24,000; profit = 24,000 − 14,000 = $10,000
Gross profit margin = 24,000 ÷ 80,000 × 100 = 30%
Mark-up = 24,000 ÷ 56,000 × 100 = 42.9%
Net profit margin = 10,000 ÷ 80,000 × 100 = 12.5%
ROCE = 10,000 ÷ 50,000 × 100 = 20%

Answer: GP margin 30%; mark-up 42.9%; net margin 12.5%; ROCE 20%

A business has a gross profit margin of 25% and a gross profit of $15,000. Find its revenue, cost of sales and mark-up.

Gross profit is 25% of revenue, so revenue = 15,000 ÷ 25% = $60,000
Cost of sales = 60,000 − 15,000 = $45,000
Mark-up = 15,000 ÷ 45,000 × 100 = 33.3%

Answer: Revenue $60,000; cost of sales $45,000; mark-up 33.3%

Liquidity Ratios

The current ratio compares current assets with current liabilities; a ratio of around 1.5:1 to 2:1 is often regarded as comfortable, though it depends on the industry. The quick (acid test) ratio leaves out inventory, because it takes time to sell, so it tests the ability to pay debts immediately; around 1:1 is usually considered safe.

Here you are checking whether the business can pay the debts that are due soon. Add up the current assets and the current liabilities first. For the current ratio, divide current assets by current liabilities; for the quick ratio, take inventory out of the current assets before dividing, and write each answer as a ratio to 1. Below, we show you how it is done, step by step.

Calculate the liquidity ratios.

Current ratio = current assets ÷ current liabilities = 60,000 ÷ 30,000 = 2 : 1
Quick ratio = (current assets − inventory) ÷ current liabilities = (60,000 − 25,000) ÷ 30,000 = 35,000 ÷ 30,000 = 1.17 : 1

Answer: Current ratio 2 : 1; quick ratio 1.17 : 1

Inventory $18,000; receivables $9,000; bank $3,000; current liabilities $20,000. Calculate and comment on the liquidity ratios.

Current assets = 18,000 + 9,000 + 3,000 = $30,000
Current ratio = 30,000 ÷ 20,000 = 1.5 : 1
Quick assets = 30,000 − 18,000 = $12,000
Quick ratio = 12,000 ÷ 20,000 = 0.6 : 1
Comment: most current assets are inventory, so the business may struggle to pay its debts immediately

Answer: Current ratio 1.5 : 1; quick ratio 0.6 : 1

A business has a current ratio of 2.5 : 1, a quick ratio of 1 : 1 and current liabilities of $16,000. Find its current assets and inventory.

Current assets = 2.5 × 16,000 = $40,000
Quick assets = 1 × 16,000 = $16,000
Inventory = current assets − quick assets = 40,000 − 16,000 = $24,000

Answer: Current assets $40,000; inventory $24,000

Asset Utilisation Ratios

Inventory turnover shows how many times inventory is sold and replaced in a year, and inventory days how long it is held. Receivables days show how long customers take to pay, and payables days how long the business takes to pay suppliers. Asset turnover shows how much revenue each dollar of assets generates.

Here you are measuring how fast inventory sells and how fast money is collected and paid. For inventory turnover, find average inventory first, then divide cost of sales by it; dividing 365 by the turnover gives inventory days. For receivables and payables days, divide the balance by the yearly credit sales or credit purchases and multiply by 365. Below, we show you how it is done, step by step.

Calculate the asset utilisation ratios.

Average inventory = (23,000 + 25,000) ÷ 2 = $24,000
Inventory turnover = cost of sales ÷ average inventory = 120,000 ÷ 24,000 = 5 times
Inventory days = 365 ÷ 5 = 73 days
Receivables days = trade receivables ÷ credit sales × 365 = 20,000 ÷ 200,000 × 365 = 36.5 days
Payables days = trade payables ÷ credit purchases × 365 = 18,000 ÷ 125,000 × 365 = 52.6 days
Asset turnover = revenue ÷ total assets = 200,000 ÷ 180,000 = 1.11 times

Answer: Inventory turnover 5 times (73 days); receivables 36.5 days; payables 52.6 days; asset turnover 1.11 times

Cost of sales $90,000; opening inventory $14,000; closing inventory $16,000. Find inventory turnover and inventory days.

Average inventory = (14,000 + 16,000) ÷ 2 = $15,000
Inventory turnover = 90,000 ÷ 15,000 = 6 times
Inventory days = 365 ÷ 6 = 60.8 days

Answer: 6 times a year, about 61 days

Credit sales $146,000, trade receivables $24,000, credit purchases $73,000 and trade payables $10,000. Find receivables and payables days and comment.

Receivables days = 24,000 ÷ 146,000 × 365 = 60 days
Payables days = 10,000 ÷ 73,000 × 365 = 50 days
Comment: customers take 10 days longer to pay than the business takes to pay suppliers, which puts pressure on cash

Answer: Receivables 60 days; payables 50 days

6.3 Importance of Ratio Analysis

Ratios turn the large figures in the financial statements into a few meaningful measures.

This makes them valuable to everyone who uses the accounts.

Importance of Ratios in General

Ratios simplify the financial statements, allow comparison between years, between businesses of different sizes and with industry averages, reveal trends and problems early, support decisions on lending, investing and credit, and help management plan and control, for example by setting targets for receivables days.

Importance of Each Category

Profitability ratios matter to owners and investors, who want a good return, and to managers, who must explain falling margins. Liquidity ratios matter to suppliers and banks, who want to be paid on time, and to managers, who must avoid running out of cash even when the business is profitable. Asset utilisation ratios matter to managers, because slow-moving inventory and slow-paying customers tie up cash, and improving them frees money for the business.

6.4 Limitations of Ratio Analysis

Ratios are useful, but they must be interpreted with care.

They point to questions to ask rather than giving final answers.

The Main Limitations

Ratios are based on past figures, which may not reflect the future. They are only as reliable as the accounts they come from, and different accounting policies, such as depreciation or inventory valuation methods, make comparisons between firms unfair. Inflation distorts comparisons over time. The statement of financial position shows one date only, which may not be typical, for example in a seasonal business. Ratios ignore non-financial factors, such as staff skills, customer loyalty and the economic environment. Finally, there is no single 'correct' ratio, since what is good depends on the industry.

6.5 Assessing the Performance of the Firm

Interpretation means explaining what the ratios show and suggesting reasons and actions.

The ratios of Zuva Wholesalers are compared below with its 2024 figures.

Interpreting the Ratios

The table compares the two years, and the comments below it explain the changes.

Profitability

The gross margin improved, perhaps through better buying prices or higher selling prices, but the net margin fell, which shows that expenses grew faster than sales and should be investigated. ROCE still improved, so overall the capital is being used more profitably.

Liquidity

Both liquidity ratios improved and are now at comfortable levels, so the business can pay its short-term debts.

Efficiency

Inventory is held 13 days longer and customers take 6.5 days longer to pay, which ties up cash. Management should reduce slow-moving inventory and tighten credit control, for example by sending statements promptly and following up overdue accounts.