Chapter Summary

• Ratio analysis pulls information out of financial accounts to judge how well a business is performing — profitability, growth, efficiency, and risk.
• Profit margins (gross profit margin & operating profit margin) show what percentage of revenue turns into profit.
• Mark-up shows profit made per item, based on cost — used to help set prices.
• Return on Capital Employed (RoCE) shows how efficiently a business uses the money invested in it to generate profit.
• Liquidity is a business's ability to pay short-term debts — measured with the current ratio and the acid test ratio.
• Ratios are only useful when compared — against previous years, competitors, or industry norms.
• Financial documents (statement of comprehensive income, statement of financial position, cash flow forecasts) are used by different stakeholders — managers, employees, owners, suppliers, lenders — to make decisions.

1. What Is Ratio Analysis, and Why Bother?

Imagine two ice cream shops both make $100,000 in sales this year. Shop A sounds impressive... until you learn Shop B only spent $40,000 to make that same $100,000, while Shop A spent $90,000. Suddenly Shop B looks like the much smarter business — even though the revenue figure alone told you nothing about that.

That's exactly the problem ratio analysis solves. It takes raw numbers buried in financial accounts (revenue, costs, profit, assets, liabilities) and turns them into percentages or ratios that can be fairly compared — between years, between competitors, or against what "good" looks like in an industry.

Ratio analysis helps answer questions like:

• Why is one business more profitable than a rival in the same industry?
• Is the business actually growing?
• How effectively is it using its assets and the capital invested in it?
• What return on investment should an investor expect?
• How risky is the business's financial structure — could it run into trouble paying debts?

2. Profit Margins

Profit margins measure how effectively a business turns its revenue into profit. Two businesses can have identical revenue but wildly different margins, depending on how well they control costs. Higher and rising margins are always the goal — it means more of every dollar of sales is actually being kept as profit rather than eaten up by costs.

AGross Profit Margin

This shows the proportion of revenue that survives after subtracting only the direct costs of making the product (the cost of goods sold) — things like raw materials and direct labour. It does not yet account for overheads like rent, marketing, or admin salaries.

BOperating Profit Margin

This is the more complete picture. It shows what percentage of revenue is left as profit after both direct costs AND overheads/expenses (rent, salaries, marketing, utilities, etc.) have been deducted. It's calculated after gross profit but before interest and tax.

3. Mark-Up

Mark-up answers a slightly different question from profit margin. Instead of asking "what % of my revenue is profit?", it asks "what % of my COST did I add on as profit for this one item?" Businesses often use mark-up to actually set their prices in the first place — it guarantees every item sold covers its cost and leaves a profit.

4. Return on Capital Employed (RoCE)

Imagine you put $100,000 of your own savings into starting a business. RoCE answers the question every investor really cares about: "was that a smart place to put my money?" It measures how effectively the business is turning the total capital invested in it (both what shareholders put in AND long-term borrowing) into operating profit.

Investors often compare RoCE against other things they could have done with the money — like leaving it in a savings account earning interest. If RoCE is lower than a savings account rate, that's a red flag: the business isn't really worth the risk.

5. Liquidity

Liquidity is a business's ability to pay its short-term debts — things like supplier bills due soon. A business that cannot pay these debts is called insolvent, and the consequences cascade quickly:

• Suppliers may stop delivering raw materials → production gets delayed.
• If an overdraft can't be repaid, banking facilities may be withdrawn and the business's credit rating suffers.
• Creditors can even force the business to stop trading and sell assets to recover what's owed.

Multiple stakeholders care about liquidity: suppliers want reassurance they'll be paid, banks/lenders want evidence loans will be repaid, and customers want confidence the business can actually deliver what they order.

ACurrent Ratio

A quick, broad measure of liquidity. It compares all current assets (cash, inventory, receivables) against current liabilities (debts due within a year).

BAcid Test Ratio (Liquid Capital Ratio)

The current ratio has a weakness: it counts inventory as a current asset, but inventory can take a long time to actually sell and turn into cash. The acid test ratio fixes this by excluding inventory entirely, giving a more realistic view of how quickly a business could cover its debts using genuinely liquid assets.

CWays to Improve Liquidity

6. Using Financial Documents

Numbers in isolation don't help anyone — what matters is who uses them and why. Different stakeholders read the exact same financial documents but look for completely different things.

AFour Big Decision Areas

• Investments — Can the business afford new non-current assets (machinery, property)? The statement of comprehensive income reveals this, and can show the impact of spending on R&D or overseas expansion.
• Financing — The statement of financial position shows the effect of taking out loans, and reveals the value of share capital and retained profit available.
• Improving Profit — Ratio analysis pinpoints which costs are dragging down profit, and the statement of comprehensive income shows how price changes affect revenue.
• Managing Assets — Documents help decide whether to lease vs. own equipment, whether to be capital-intensive or labour-intensive, and whether to maintain or dispose of ageing equipment.

What to Memorise

Key vocabulary:

Golden units rule: Always check whether figures are raw ($14,520), in thousands ($000), or millions ($m) — convert carefully before calculating, and give answers to 2 decimal places unless told otherwise.

Concepts Checklist

• I can explain why ratio analysis is more useful than looking at raw profit figures alone
• I can calculate and interpret the gross profit margin
• I can calculate and interpret the operating profit margin
• I know how a business can improve its profit margins (and the risks of each method)
• I can calculate mark-up and explain how it differs from gross profit margin
• I can calculate capital employed and RoCE
• I can use RoCE to compare investment options and make recommendations
• I can explain what liquidity means and why it matters to different stakeholders
• I can calculate the current ratio and the acid test ratio
• I understand why the acid test ratio excludes inventory
• I can list and evaluate ways to improve liquidity
• I know which stakeholders use financial documents, and why
• I can explain how financial documents inform investment, financing, profit, and asset decisions

Exam Tips & Common Mistakes