Contents: 8 sections
Cambridge IGCSE Accounting 0452 · Core and Extended
Syllabus points
- Calculate the profitability ratios.
- Calculate the liquidity ratios.
- Calculate the ratios measuring the use of resources.
- Select the correct figures from the financial statements for each ratio.
Profitability
Gross margin = gross profit / revenue x 100
Profit margin = profit for the year / revenue x 100
Mark-up = gross profit / cost of sales x 100
Return on capital employed (ROCE) = profit / capital employed x 100
Capital employed is the long-term finance of the business: closing capital plus any non-current liabilities. At IGCSE, if the question gives no loan, capital employed is simply the closing capital.
Liquidity
Current ratio = current assets : current liabilities
Liquid ratio, also called the quick ratio or acid test = (current assets − inventory) : current liabilities
Both are written as a ratio to one, such as 1.6 : 1, not as a percentage.
Inventory is removed in the second ratio because it is the least liquid current asset: it has to be sold before it becomes cash, and if sold on credit it then has to be collected.
Working capital = current assets − current liabilities. This is an amount, not a ratio.
Use of resources
Rate of inventory turnover = cost of sales / average inventory, in times per year
Inventory turnover in days = average inventory / cost of sales x 365
Trade receivables turnover = trade receivables / credit sales x 365 days
Trade payables turnover = trade payables / credit purchases x 365 days
Average inventory is opening plus closing, divided by two. If only the closing figure is given, use it and say so.
Choosing the right figures
More marks are lost here than on the arithmetic, so check each of these before calculating.
- Inventory ratios use cost of sales, never revenue, because inventory is held at cost and both figures must be on the same basis.
- Receivables and payables ratios use credit sales and credit purchases. Cash customers never became receivables. If only a total is given, use it and note that the period will be understated.
- Revenue means net revenue, after sales returns.
- ROCE uses closing capital employed unless the question gives an average.
- The current ratio uses all current assets, including any prepayment.
A worked set
Revenue $240 000, cost of sales $156 000, expenses $54 000. Inventory $18 000 at the start and $22 000 at the end. Trade receivables $26 000, all sales on credit. Bank $9 000. Trade payables $17 000. Capital employed $150 000.
Gross profit is 240 000 minus 156 000, which is $84 000, so the gross margin is 84 over 240, which is 35%.
Profit for the year is 84 000 minus 54 000, which is $30 000, so the profit margin is 30 over 240, which is 12.5%.
Mark-up is 84 over 156, which is 53.85%.
ROCE is 30 000 over 150 000, which is 20%.
Current assets are 22 000 plus 26 000 plus 9 000, which is $57 000. The current ratio is 57 000 to 17 000, which is 3.35 : 1.
The liquid ratio removes inventory: 35 000 to 17 000, which is 2.06 : 1.
Average inventory is 18 000 plus 22 000, divided by 2, which is $20 000. The rate of inventory turnover is 156 000 over 20 000, which is 7.8 times, and in days that is 20 000 over 156 000, times 365, which is 47 days.
The receivables turnover is 26 000 over 240 000, times 365, which is 40 days.
Presentation
- Show the formula, then the figures, then the answer. If the arithmetic goes wrong, the formula still earns its mark.
- Give profitability answers as percentages, liquidity as ratios to one, and turnover as days or times as the question asks.
- Round to the number of decimal places the question uses, and to whole days for turnover periods.
- Keep the units: writing 3.35 without ": 1" is incomplete.
Common mistakes
- Using revenue instead of cost of sales in an inventory ratio.
- Including inventory in the liquid ratio.
- Using total sales when credit sales are given.
- Expressing a liquidity ratio as a percentage.
- Using opening capital in ROCE when the question expects the closing figure.
- Leaving out a prepayment from current assets.
- Giving an answer with no formula and no working.