Calculation of accounting ratios

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Cambridge O Level Accounting 7707

Calculation of Accounting Ratios

The big idea: A ratio turns two figures into one comparable number. Eight ratios cover the three questions an owner asks: is the business profitable, can it pay its debts, and how quickly do inventory, customers and suppliers turn into cash?

Summary — What This Chapter Covers

Profitability: gross margin, profit margin, return on capital employed (and mark-up).
Liquidity: current ratio and liquid (acid test) ratio.
Efficiency: rate of inventory turnover (times), trade receivables turnover and trade payables turnover (days).
Know each formula, show the working, and state the unit: %, : 1, times or days.

1. The Data

Syllabus 6.1 · Paper 1 & 2

One business, every ratio

All the worked examples in this note use Amira Trading’s figures. Write each formula, then substitute, then give the answer with its unit. Round percentages to two decimal places and days up to whole days unless told otherwise.

Amira Trading — year ended 31 December 2025
Income statement extract	$	Statement of financial position extract	$
Revenue (of which credit sales $150,000)	180,000	Inventory	16,000
Opening inventory	14,000	Trade receivables	18,000
Purchases (all on credit)	117,000	Bank	3,500
Closing inventory	16,000	Trade payables	13,000
Cost of sales	115,000	Other payables	2,000
Gross profit	65,000	Capital at 31 December 2025	96,000
Expenses (including loan interest $1,200)	38,000	Loan repayable 2030	24,000
Profit for the year	27,000

2. Profitability Ratios

Syllabus 6.1 · Paper 1 & 2

Gross margin, mark-up, profit margin, ROCE

Profitability ratios Gross margin = Gross profit ÷ Revenue × 100
Mark-up = Gross profit ÷ Cost of sales × 100
Profit margin = Profit for the year ÷ Revenue × 100
ROCE = Net profit before interest ÷ Capital employed × 100

Capital employed: for a sole trader, capital + non-current liabilities; for a limited company, issued shares + reserves + non-current liabilities (debentures). Profit before interest is used because the loan is part of capital employed.

Worked Example

Calculate Amira Trading’s gross margin, mark-up, profit margin and return on capital employed.

Worked Example — limited company

A company has ordinary shares $160,000, 8% non-redeemable preference shares $40,000, general reserve $30,000, retained earnings $50,000 and 10% debentures $70,000. Profit for the year (after debenture interest) was $42,000. Calculate ROCE.

Practice Question 1

Revenue $64,000, cost of sales $40,000, profit for the year $9,600. Calculate the gross margin, the mark-up and the profit margin.

3. Liquidity Ratios

Syllabus 6.1 · Paper 1 & 2

Can the business pay its short-term debts?

Liquidity ratios Current ratio = Current assets ÷ Current liabilities (working capital ratio)
Liquid (acid test) ratio = (Current assets − Inventory) ÷ Current liabilities (quick ratio)

The liquid ratio leaves out inventory because it must be sold, and often sold on credit, before it becomes cash. Both are written as x : 1.

Worked Example

Calculate Amira Trading’s current ratio and liquid ratio.

Practice Question 2

Inventory $7,200, trade receivables $5,400, cash $900, current liabilities $9,000. Calculate the current ratio and the liquid ratio.

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Also in the full note

How fast things turn over
What the number tells the owner

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Calculation of accounting ratios