ExpertRatios
Learning outcomes
- Calculate key accounting ratios related to profitability, liquidity, efficiency, and position
- Explain the interrelationships between ratios
Objective A: Key Ratios
Profitability Ratios
| Ratio | Formula | Purpose |
|---|---|---|
| Gross profit margin | Gross profit ÷ Revenue × 100 | Measures profitability after cost of sales |
| Operating profit margin | Operating profit ÷ Revenue × 100 | Measures profitability after operating expenses |
| Net profit margin | Profit for the year ÷ Revenue × 100 | Measures overall profitability |
| Return on capital employed (ROCE) | Operating profit ÷ Capital employed × 100 | Measures return generated on long-term capital |
| Return on equity (ROE) | Profit for the year ÷ Total equity × 100 | Measures return for shareholders |
Capital employed = Total assets − Current liabilities (or Equity + Non-current liabilities)
Liquidity Ratios
| Ratio | Formula | Purpose |
|---|---|---|
| Current ratio | Current assets ÷ Current liabilities | Measures short-term solvency |
| Quick ratio (acid test) | (Current assets − Inventory) ÷ Current liabilities | Measures immediate solvency |
Efficiency Ratios
| Ratio | Formula | Purpose |
|---|---|---|
| Inventory turnover | Cost of sales ÷ Average inventory | How many times inventory is sold per year |
| Inventory days | Inventory ÷ Cost of sales × 365 | Days inventory is held |
| Receivables days | Trade receivables ÷ Revenue × 365 | Days to collect from customers |
| Payables days | Trade payables ÷ Cost of sales × 365 | Days to pay suppliers |
| Asset turnover | Revenue ÷ Capital employed | Revenue generated per £ of capital |
Position (Gearing) Ratios
| Ratio | Formula | Purpose |
|---|---|---|
| Gearing | Debt ÷ (Debt + Equity) × 100 | Proportion of long-term finance from debt |
| Interest cover | Operating profit ÷ Finance costs | Ability to pay interest from profits |
Must-Know Formulas
ROCE = Operating profit ÷ Capital employed × 100
Current ratio = Current assets ÷ Current liabilities
Quick ratio = (Current assets − Inventory) ÷ Current liabilities
Gearing = Debt ÷ (Debt + Equity) × 100
Interest cover = Operating profit ÷ Finance costs
These are the most frequently examined ratios. Learn them by heart.
Objective B: Interrelationships Between Ratios
Ratios do not exist in isolation — they are interconnected:
-
ROCE = Operating profit margin × Asset turnover. A company can improve ROCE by either increasing its margin (charging higher prices or reducing costs) or increasing asset turnover (generating more revenue from the same asset base).
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Reducing receivables days improves the current ratio and quick ratio because cash is collected faster, increasing cash balances.
-
Increasing gearing may improve ROE (because debt is cheaper than equity due to tax relief on interest), but it reduces interest cover and increases financial risk.
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Reducing inventory days improves cash flow and the quick ratio, but may risk stockouts if taken too far.
A company has operating profit of £120,000 and capital employed of £800,000. What is the ROCE?
A company has current assets of £200,000 (including inventory of £80,000) and current liabilities of £150,000. What is the quick ratio?
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ACCA FA — Financial Accounting Practice Exam 2
A complete mock exam replication for ACCA Financial Accounting (FA). This 2-hour, 100-mark assessment covers double-entry accounting, ledger adjustments, group consolidations, and financial statement production. Features diverse business scenarios including tech startups, heavy manufacturing, and agriculture.