Contents: 8 sections
Cambridge IGCSE Accounting 0452 · Core and Extended
Syllabus points
- Explain what each ratio measures and comment on a change.
- Suggest causes of a change and actions to improve the position.
- Explain the interested parties and what each one looks for.
- Explain the limitations of ratio analysis.
Answering an interpretation question
A calculation earns one mark. A comment earns more, and only if it does three things:
- Say what happened, using the figures.
- Say why it might have happened, with a cause that fits the direction.
- Say what it means for the business, or what should be done.
"The gross margin fell from 38% to 31%" is step 1 only. "The gross margin fell from 38% to 31%, probably because selling prices were cut to compete, which means every dollar of sales now generates 7 cents less to cover expenses" is a full answer.
Profitability
Gross margin measures trading. It changes only through selling prices, purchase costs or the sales mix.
Causes of a fall: prices cut to compete, supplier prices risen without a price increase passed on, a shift to lower-margin goods, theft of inventory, closing inventory undervalued.
Actions: raise selling prices, find cheaper suppliers, reduce theft, review the product mix. Each has a cost, and naming it lifts the answer. Raising prices may lose customers; cheaper suppliers may bring poorer quality.
Profit margin measures trading and expenses. Compare it with the gross margin to locate the problem:
- Both fall by roughly the same amount: the problem is in trading.
- Gross margin steady, profit margin falls: the problem is expenses.
- Gross margin rises, profit margin falls: both moved, and expenses rose by more.
That comparison is the single most useful move in the whole topic, and it is available whenever a question gives both ratios.
ROCE measures how well the business used all the money invested in it. Compare it with what the money would earn in a bank deposit: a lower ROCE means the owner would be better off closing and depositing the funds. ROCE can also fall for a good reason, when a large asset is bought late in the year and contributes a full amount to capital employed but only a few months of profit.
Liquidity
The often-quoted benchmarks are a current ratio near 2 : 1 and a liquid ratio near 1 : 1. Treat them as a guide, not a rule, and say so. A supermarket runs safely well below 1 : 1 because it sells for cash and holds few receivables.
Too low means the business may not be able to pay its debts as they fall due, so it risks losing supplier credit, losing cash discounts, having an overdraft called in, and ultimately failing even while profitable.
Too high is also a criticism, and this half is usually missing from weak answers. Excess current assets are idle resources: too much cash earning nothing, too much inventory risking obsolescence and storage costs, or receivables allowed to run too long. Money tied up in current assets is money not earning a return, which drags ROCE down.
Use of resources
Inventory turnover. Faster usually means goods sell well and less cash is tied up. Too fast may mean stock levels so lean that sales are lost. A slowing rate suggests falling demand, obsolete lines or over-buying.
Receivables turnover. Compare it with the credit terms the business offers. Forty-five days against terms of 30 days means credit control is weak, and the answer should say so rather than just calling the number high. Too short can mean terms so tight that customers go elsewhere.
Payables turnover. Longer means more free finance from suppliers. Too long risks losing cash discounts and losing the supplier's goodwill.
Set the receivables period against the payables period. If customers pay in 40 days and suppliers are paid in 30, the business is paying out before collecting and needs finance to bridge the gap. Reverse them and supplier credit is funding the receivables.
What the interested parties look for
| Party | Ratios they care about most |
|---|---|
| Owner | ROCE, profit margin |
| Bank considering a long loan | ROCE, profitability, liquidity |
| Supplier giving credit | Current and liquid ratios, payables turnover |
| Employee | Profitability and whether the business is growing |
| Potential buyer | All of them, and the trend over several years |
Limitations of ratio analysis
- Ratios are based on historic figures and users are making decisions about the future.
- A statement of financial position is a snapshot at one date, and a seasonal business looks very different a month either side.
- Businesses use different accounting policies, so two sets of ratios may not be comparable.
- Ratios ignore everything not measured in money: staff skill, customer loyalty, the reputation of the business, the state of the economy.
- Comparisons only work between businesses of a similar size in the same industry.
- Figures can be manipulated, for example by settling payables just before the year end to improve the current ratio.
- A ratio shows what happened, never why. That has to be investigated.
- One year's figures mean little. A trend over several years means much more.
Common mistakes
- Calculating the ratio and stopping, with no comment.
- Restating the ratio in words as though that were the explanation.
- Giving a cause that does not fit the direction of the change.
- Saying a high current ratio is always good.
- Using profit figures to explain a liquidity ratio, or the reverse.
- Comparing a small sole trader with a large company and drawing a conclusion.
- Suggesting improvements with no mention of their cost or risk.