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Revision:A Level Accounts Module 4 - Ratio Analysis

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TSR Wiki > Study Help > Subjects and Revision > Revision Notes > Accounting > A Level Accounting Module 4 - Ratio Analysis

Ratio analysis

In this section we look at the assessment of business performance - ratio analysis. The sections we cover are:

Uses of ratios
Ratio analysis
Profitability and liquidity
Limitations of ratios

1 Uses of ratios
2 Ratio analysis
3 Profitability ratios
4 Efficiency ratios
5 Profitability and liquidity
6 Limitations of ratios
- 6.1 Common limitations of ratios
7 Exam tips
8 Comments

Uses of ratios

When assessing the performance of a business, we will normally use the financial data to make this assessment. Profits are the main yardstick use to assess whether a firm has performed well or poorly. However, profits alone will not tell us too much.

For example, if a firm earned a profit in one year of £15,000, could we tell if the firm had preformed well? Actually, we would probably need to know much more about the firm and the industry it operated in, as well as the prevailing economic and other external factors that affected the firm.

Before we even begin to look at how assessment is performed, we should first of all consider how we are going to use the data. One year's worth of information is not normally enough. We will need some other standard to measure our data against. The following basis of comparison are often used when assessing performance

Past performance

Comparison of present performance with previous year's performance will tell us a lot about the direction the firm is moving in - is it improving worsening or maintaining performance levels compared with earlier years? Ideally a number of previous year's data can be used to establish a trend performance (the overall direction after taking into account minor fluctuations, although two years of figures may shed some light on which way the firm is moving).

Industry analysis

Comparing one firm's performance with another is a meaningless activity unless the firms are similar. It would be no use comparing a giant multinational with a small butcher for instance. Comparison of firm operating in the same industry will give us much more meaningful information about how a firm is performing compared with rival competitions. This will be even more meaningful the firms are of similar size (measured in either turnover or capital employed). Industry analysis also allows us to see how firms are coping with changes in external factors that affect them in a similar way. For example, analysing how football clubs have coped with the collapse of ITV digital, or how mobile phone companies are coping with the slow take up of third generation phones.

Ideally, we could combine the analysis of past performance and industry analysis to see how the industry as a whole has performed over a number of years. This will provide valuable information to see which firms are struggling and which firms are managing to perform well in the circumstances. For example, if profits have been rising over a number of years then this may seem an indicator of good performance. However if other firms have seen profits rise even more quickly, them the good performance would have to be called into question.

Variance analysis - comparison with budgeted data

Most firms will have expectations for future profits even if they do not produce full budgeted data. It will be useful for firms to compare their own budgeted data performance with the actual performance. Analysis of any variances (differences between budgeted data and actual data) will provide useful information and allow the firm to investigate why the firm is not performing to the budgeted expectations (whether positive or negative).

Ratio analysis

Assessing the performance of a business requires us to be very clear in actually defining what we are trying to assess. In most cases, profits are seen as the main objective of any firm. However, there are many other areas of a firm that, although not directly affecting profit, will have an indirect affect of the profitability of the firm.

To assess the performance of the firm profits alone cannot tell us much information. We need some standard to assess items, such as profits, sales and so on. Ratio analysis is the combination of figures from the financial statements of the firm (profit and loss accounts and balance sheets) into a format where judgements can be made on the overall performance of the firm. For example, comparing profits to sales, or profits to capital will allow us to see how effective the firm is in generating profits out of sales. Alternatively, comparing profits to capital gives us some idea of profits in relation to the size of the firm. A ratio is simply two or more figures compared with each other to produce an overall result, which is more meaningful than the original figures alone.

Ratios require formulas to be memorised. There are a number of different ratios that can be used to assess different areas of the firm. Ratios are therefore grouped according to type, or area.

Profitability ratios

These ratios focus specifically on the profits of the firm (both gross and net profits). The profits are compared with sales, capital to provide some standard for comparison. These ratios in this group are as follows:

Return on capital employed
Gross profit margin (gross profit in relation to sales)
Net profit margin (net profit in relation to sales)
Mark-up

Liquidity

Liquidity is a measurement of whether the firm has enough cash available for immediate use. These ratios focus on the ability of the firm to meet day-to-day running requirements. They look at the liquid resources (resources easily convertible to cash) and compare these with the short-term debts of the firm that will require payment in the next few weeks or months. Many small or new firms find liquidity to be one of their greatest problems. The ratios used to assess liquidity are as follows:

Current ratio (net current asset ratio)
Acid test ratio (liquid capital ratio)

Liquidity ratios are sometimes known as solvency ratios

Efficiency

There are other ratios, which are more likely to be used by internal groups to the firm (i.e. mangers and directors) for assessing performance. Although these ratios do not look specifically at profits, these ratios will measure the overall financial efficiency of the firm which could eventually affect profits. Common areas to assess are how a firm manages its stockholding, or its debtor and creditor control. Also, how efficient the firm is in controlling expenditure will also be assessed with these ratios. The activity ratios will cover:

Stock turnover (stockturn)
Debtor collection period (debtor days)
Creditor collection period (creditor days)
Turnover in relation to fixed assets
Turnover in relation to net current assets
Overheads in relation to turnover

Profitability ratios

For most firms, achieving profits are the main goal of the organisation. In limited companies this is even more likely to be the case. This is because the company is owned by shareholders who, expect possibly in the case of private limited companies, have purchased shares with the aim of maximising their returns. The profitability ratios will analyse accounts from the perspective of the size of the profits, and then compare these profits to other figures.

For this section we will use the following extracts from the final accounts of Buzz Ltd.

Buzz Ltd - extracts from final accounts for year end

-	2001	2002
-	£	£
Turnover	16,555	23,220
Cost of goods sold	12,345	18,650
Gross profit	4,210	4,570
Overhead expenditure	2,540	3,275
Net profit	1,670	1,295
-
Capital employed	46,700	49,850

The ratios and their formulae are as follows:

Return on capital employed

$\displaystyle \mathsf{Return\ on\ capital\ employed\ (ROCE)} = \frac{\mathsf{Net\ (or\ operating)\ profit} \times 100}{\mathsf{Capital\ employed}}$

Have a go at working this out for Buzz and then follow the link below to see how you got on.

What do these results tell us?

Well, firstly the ratio expresses the profits in relation to the capital and expresses it as a percentage, which is measure of the size of the firm. Therefore, it is meaningful to compare between years and also between other firms as they all relate to the size of the firm.

A return on capital employed (ROCE) should be as high as possible. A negative ROCE would mean that the firm had made a loss. In the UK, ROCEs are typically between 5% and 15%. This will depend on the sector in which the firm operates.

A return of 2-4% as experienced by Buzz does not look too encouraging. But the following factors may also need to taken into account:

External factors, such as an economic downturn that affects the industry. Remember however, not all firms are affected in the same way by economic downturns and upturns. For example, the takeaway Pizza market was always though to be an industry that would perform better during an economic downturn (perhaps because people would resort to takeaways Pizzas rather than restaurant Pizzas). However, in the period of steady economic growth the demand for takeaway pizzas has increased as well which was not expected.

Comparable data from other firms. The firms must be in the same industry and should ideally be of a similar size so that meaningful comparisons can be made.

Profits may low due to one-off factors (such as high research expenditure - which is only capitalised in the UK according to strict guidelines - meaning that many UK firms have to put a lot of their research expenditure into the profit and loss account, rather than claiming the creation of an 'asset')

Profit margins

Both the gross profit margin and the net profit margin are calculated in a very similar way (the only difference is in the measure of profits used in the ratio - gross and net profits). It makes sense to consider these ratios together, as they will often be affected in the same way by changes affecting the firm.

The formulae for the profit margins are as follows:

$\displaystyle \mathsf{Gross\ profit\ margin} = \frac{\mathsf{Gross\ profit} \times 100}{\mathsf{Turnover}}$

$\displaystyle \mathsf{Net\ profit\ margin} = \frac{\mathsf{Net\ profit} \times 100}{\mathsf{Turnover}}$

Have a go at working out the gross and net profit margins for Buzz and then follow the link below to see how you got on.

Gross profit margin - what does this tell us?

This ratio compares gross profits to the sales revenue. It tells us how much of the sales revenue earned actually consists of gross profits - and therefore, how much consist of costs of goods sold.

For Buzz Ltd, in 2001 25.4% of the sales revenue was gross profits. This fell to 19.7% in 2002. A fall in this ratio means that for every £1 of sales generated by the firm, less profit will be earned. It certainly does not mean that profits are falling - in fact, although the gross profit margin has fallen, the gross profits in 2002 are actually slightly higher than those of 2001.

Net profit margin - what does this tell us?

Similar to the gross profit margin, this ratio compares the net profit to the sales revenue. This tells us how much (as a percentage) or the firm's sale revenue is made up of net profits. For Buzz Ltd, the net profit margin falls from 10.1% to 5.6% over the two-year period. Therefore in 2001, for every £1 of sales, 10.1p net profit was generated. This fell by the next year to 5.6p in every pound. A falling net profit margin, as with the gross profit margin, doe into mean that net profits have fallen. However, in this case, the net profits have fallen in 2002 compared with 2001.

What do falling profit margins mean?

The reason for a falling profit margin mean that the 'gap' between sales and the measure of profit has narrowed. This could be due to one or more of the following:

Selling prices have fallen
Costs have increased

Imagine if the firm reduced its selling price to boost sales volume. This may lead to higher profits. However, the profits on each sale made will be lower due to the lower selling price. This would lead to an overall reduction in the net and gross profit margins - even though profit levels have risen.

It is possible that the falling profit margins would be part of the firm's policy. However, it may also be the case that profit margins fall due to circumstances beyond the firm's control.

Possible reasons are as follows

Higher cost of materials or higher labour costs in production
Lower selling prices - possible due to a promotional campaign or other special offer
Increased competition forcing prices down
Switch from profit maximisation to sales maximisation (i.e. price cuts)

Supermarkets operate with very low profit margins. Supermarkets, however, are very profitable. This is because, although they earn very little profits on each 'unit' sold, there output is sold at a very rapid rate - thus the overall profits quickly build up.

An antique dealer would not expect sales to be achieved in such as rapid rate. This means that the antique dealer would probably have to charge high selling prices - which mean a higher profit margin - in order to compensate for the slower rate of sales. This means that profits build up at a slower rate, but in bigger steps.

Mark-up & margin

The terms mark-up and margin are frequently used by those in business and accounting, often in an incorrect manner. Each of these terms refers to the relationship between the selling price of output and the cost of that output.

Mark-up refers to the amount of profit added on to the cost of a unit of output in order to set a selling price - normally added on a percentage of the cost

Margin refers to the amount of profit in the selling price of a unit of output - normally the percentage of the selling price that is profit

Both terms are looking at profits but from different perspectives, so there is bound to be some link between the two measures.

Both mark-up and margin are often expressed in percentage terms. For example, the phrase 'mark-up output by 20%' would mean that to set the selling price, the cost of the output is increased by 20%.

Example 1

Output costs £80 to produce per unit. The firm has decided to set a selling price based on a 25% mark-up.

What will be the selling price? Have a go at working this out and then follow the link below to see how you got on.

The margin refers to the percentage of the selling price that is profit (the remaining percentage must therefore be costs). For example, the phrase 'profit margin of 50%' would mean that out of the selling price, half of the revenue is profit, and the other half is costs.

Example 2

A firm sells output for £100 per unit, with a profit margin or 20%.

What will be the cost of production? Have a go at working this out and then follow the link below to see how you got on.

Notice how examples 1 and 2 are actually using the same data. The mark-up in example 1 was 25%, the margin is example 2 was 20% but both used the same raw data. This will mean that we should be able to calculate the mark-up if we already know the margin, or vice versa.

If we convert the percentages used into fractions, then we get a clearer idea:

Mark-up, 25% = 1/4

Margin, 20% = 1/5

The relationship can be summarised as follows:

Mark-up	-	Margin
$\displaystyle \frac{1}{n}$	Therefore	$\displaystyle \frac{1}{n +1}$

Margin	-	Mark-up
$\displaystyle \frac{1}{n}$	Therefore	$\|displaystyle \frac{1}{n - 1}$

Example 3

Goods which costs £270 to produce are sold at a mark-up of 33.3%

What is the profit margin? Have a go at working this out and then follow the link below to see how you got on.

Efficiency ratios

These are mainly measures of financial control. They are rarely seen in media headlines (or any other business stories) because they do not dramatically affect the performance (either in profitability or liquidity) of the firm. As a result, these ratios are more likely to be of interest to internal stakeholders of the firm, (managers, budget holders, etc).

These ratios affect how efficiently the firm operates in terms of its working capital management. As stated earlier, these ratios do not directly affect profit, but improvements in these could affect future profitability.

Stock turnover

This ratio measure how quickly the firm 'turns over' (i.e. sells) its stocks. It, measures the rate of stock turnover in terms of the time the average holding of stock is held by the firm.

The formula to calculate the stock turnover is as follows:

$\displaystyle \mathsf{Stock\ turnover} = \frac{\mathsf{Cost\ of\ goods\ sold}}{\mathsf{Average\ stock}}$

The average stock is simply the arithmetical mean of the opening and closing stock levels:

[Unparseable or potentially dangerous latex formula. Error 2 ]

This will give us an answer in terms of the 'number of times' stock is sold during a year.

From the following data have a go at calculating the stock turnover ratio. Follow the link below to see how you got on.

-	£	£
Sales	-	55,700
Less cost of good sold:	-	-
Opening stock	6,590	-
Add Purchases	32,800	-
-	39,390	-
Less closing stock	7,850	31,540
Gross profit	-	24,160

There are no 'ideal' figures for what a firm's stock turnover should be. Firms that sell consumer goods (especially perishable goods - supermarkets for instance) would be expected to have a high stock turnover (perhaps as high as 100 or more). Firms selling industrial goods, or slow moving consumer goods (jewellers, for instance) may have a lower stock turnover of less than 10.

There is a link here with the profit margins. As stated earlier, firms can operate with low profit margins, if they have a rapid stock turnover. Firms with lower stock turnover (a lower rate of sales) will need higher profit margins to 'compensate'.

Debtors collection period and creditors payment period

These ratios measure how long the firm takes to settle its accounts with both customers and suppliers. They give a result in terms of the average number of days taken by our debtors to pay us, and how long the firm takes on average to pay its creditors.

There are no ideal figures for debtor days and creditor days (common alternative names for these ratios). Most firms will offer free credit periods to other firms so we would expect to see result of at least 30 days or more. A survey taken in the last five years found that the average length for debtor days would in the UK was over 70 days.

Main areas to look out for would be as follows:

Increase in the length of time taken to settle accounts
Debtors collection period rising far quicker than creditor payment period

The firm would be concerned if there was a large discrepancy between the time taken to collect from debtors and the time taken to pay its creditors. These should be roughly the same. A firm could reduce the debtor's day figures by offering discounts (or larger discount if already offered) for immediate or prompt settlement of accounts.

The formulae used to calculate these ratios are as follows:

$\displaystyle \mathsf{Debtors\ collection\ period} = \frac{\mathsf{Debtors} \times 365}{\mathsf{Credit\ sales}}$

$\displaystyle \mathsf{Creditors\ payment\ period} = \frac{\mathsf{Creditors} \times 365}{\mathsf{Credit\ purchases}}$

In most cases, all the purchases and sales will be on credit terms but be careful not to include cash sales or purchases in this ratio.

The result will be in the form of 'number of days' taken.

Use the following data and have a go at working out the debtors collection period and creditors payment period. Once you have had a go follow the link below to see how you got on.

-	2000	2001
-	£	£
Sales	189,000	232,200
Purchases	132,400	176,000
Debtors	15,600	27,890
Creditors	11,745	15,410

Other efficiency ratios

The following ratios are used mainly to examine if the firm is controlling its expenses efficiently i.e. expenses are increasing disproportionately fast), or if assets are being used effectively in generating sales.

The following ratios may be used for this purpose:

Asset turnover ratio - turnover in relation to fixed assets

$\displaystyle \mathsf{Asset\ turnover\ ratio} = \frac{\mathsf{Sales\ turnover}}{\mathsf{Net\ assets}}$

This shows how 'effectively' the net assets (total assets less total liabilities) of the firm are being used to generate turnover. It will depend on the industry, but a rising figure may indicate that assets are being used more efficiently to generate extra sales.

===Turnover in relation to net current assets

$\displaystyle \mathsf{Turnover\ to\ net\ current\ assets} = \frac{\mathsf{Sales\ turnover}}{\mathsf{Net\ current\ assets}}$

Similar to the asset turnover ratio, this shows how efficiently the net current assets (current assets less current liabilities) are being used to generate sales. Again, a rising figure would indicate that working capital is being used more effectively to generate sales. However, working capital is more volatile than net assets, so this ratio may be subject to distortions.

Both the above ratios will be subject to industry specific factors. For example, a capital intensive firm is likely to have a higher value for net assets than a labour intensive firm, - which would lead to a lower asset turnover ratio.

Overheads in relation to turnover

$\displaystyle \mathsf{Overheads\ to\ turnover} = \frac{\mathsf{Overheads}}{\mathsf{Slaes turnover}}$

This ratio is similar to the profit margins in that it expresses the result as a percentage of sales. A rising figure here would indicate that the firm's non- productive expenses (profit and loss expenses) are rising faster than sales. This may mean the firm is becoming less efficient in controlling its own expenses. However we would need to examine the data further to see why this was happening. It may be that this rises as the firm launches an expensive marketing campaign to boost sales, for instance.

Use the following data and have a go at working out these three ratios. Once you have had a go follow the link below to see how you got on.

-	2002	2003
-	£	£
Sales	56,000	64,000
Cost of goods sold	34,000	37,600
Gross profit	22,000	26,400
Overheads	14,300	21,400
Net profit	7,700	5,000
-
Net current assets	11,500	7,590
Net assets	79,000	82,000

Profitability and liquidity

The fact that a firm is profitable does not guarantee that it will have enough cash to remain trading (being 'solvent'). It may seem surprising that a firm that is making a profit or has made profits in the past can run out of cash, but this disbelief stems from a common misunderstanding of what the terms 'cash' and 'profit' actually mean. People often assume that at the end of each year there is an amount of money in the firm's bank account equivalent to its profit and that this can be withdrawn and spent by the owner(s) of the firm. However, it is more likely that the profits will be tied up in many different areas of the firm. For example, the profit may have been used to acquire new equipment or stock; if the goods have been sold on credit the revenue may still be in the form of debtors. It is possible, therefore, for a firm to be profitable but to also be short of cash because:

Differences between cash and profit

Many sales are on credit. These sales will be counted immediately towards the profit even though the cash from the sale may actually appear months later. Accepting and order for sales may mean that a firm has to spend more on production without generating the cash flow from the sale until much later. This problem is known as overtrading - where a firm experiences cash flow by accepting extra sales without the necessary cash flow to produce the output.

The firm may have invested heavily in capital items such as equipment. Although this will involve a cash outflow, the 'cost' of these assets in the profit and loss account will be 'written off' as depreciation over the working life of the asset. This means that capital expenditure will affect cash flow not profit.

The firm may have invested in stocks. These will appear as an asset on the balance sheet but will not appear as a cost until they are used up. The cash outflow will occur when they are bought.

If a firm has paid for something in advance but not used it up yet (e.g. it has paid for the use of some equipment or property in advance) this will reduce cash flow but will only be recorded as a cost when the service or good is used up next period. Conversely, if the firm has used up something, such as electricity, this will count as a cost even if the bill has not been paid for. This is summarised in the accruals concept.

Why is cash flow important?

Firms usually exist in order to make a profit. This may not always be their main objective. It is also, however, important for firms to monitor their cash flow position. This is because a firm will need cash to pay for the daily running of the business.

Cash will be needed to pay wages, to pay bills, to pay suppliers and for the general upkeep of the firm. If a firm cannot pay one of its creditors, then the firm may ultimately face a bankruptcy order forced on to the firm by those who it cannot pay. If it cannot pay its own workers then industrial action is likely to occur.

Sufficient levels of cash are needed to ensure that a firm is liquid; it is important, therefore, that managers track the cash flow position of the business. This is likely to involve drawing up cash flow forecasts which estimate the likely amounts of cash inflows and cash outflows over the near future. Very short-term cash flow forecasts may be particularly important for small or newly established firms, which often have to target cash flow over a daily or weekly period rather than on a month by month basis. This is because a new or small firm is thought to be more likely to fail than a larger firm. As a result, the sources of cash flow available to a larger firm (such as extended credit periods offered, or extensions to overdrafts) may not be offered to small firms if their cash flow becomes negative.

Which is more important - cash or profit?

In the long run there is probably little point undertaking an activity if the value of the sale is less than the value of the inputs used up (i.e. if turnover is less than costs). This means that over time a firm will need to make a profit if it is to continue with an activity. Firms will generally measure not just the absolute size of the profits but also their size relative to the capital employed, to decide if an activity is worthwhile.

In the short run, however, the priority is to keep the business going; this means the firm must be liquid and have sufficient cash flow. There is little point in getting involved in a project that is potentially profitable if, in fact, the business will not survive long enough to be able to sell the products it produces. Firms must pay attention to their cash flow as well as their profit. If a bill has to be paid, cash is likely to be regarded as more important than profit; however, when reviewing the firm's activities over a period of time it will usually be expected to achieve a suitable rate of return in terms of profit.

A firm must be careful when engaging in activities to monitor the effect on each transaction on both profit and cash flow. Many firms may forget that the cash flow will be, in some cases, more important than the profits.

Limitations of ratios

It is important to realise that with ratio analysis that the question will rarely focus on the calculation of ratios alone, most of the time the calculation of the ratio will only be the first step on some investigation into some aspect of business performance. Therefore it is especially important that you can interpret and analyse what the result of the ratios actually mean,

Areas that are important in ratio analysis are as follows:

Analysing the ratios of a particular area of a firm (e.g.: profitability, efficiency, liquidity, etc.)
Limitations of ratios
A basis for comparing the performance of two firms or one firm over time
As a tool to help decide a firm's strategy (e.g. has it a safe liquidity position for expansion, or analysis of gearing to help decide on the best form of finance)

When answering any question on ratios you must consider the following factors:

What type of firm are we dealing with?
What is the size of the firm and should this have any effect on the ratios?
Will the time of year have any effect on the ratios? (see liquidity ratios section for example)
Have we got enough information to make any serious conclusions?
What external factors are important?
Are the accounts supplied reliable? Ratios are only as accurate, true and fair as the original figures from which they were calculated

Obviously, the first stage should be to calculate the ratios in the correct manner. Once you have completed this then it is time to start to interpret the results that you have calculated.

This interpretation can be in the form of your theoretical knowledge of what the ratio tells us. For example, the current ratio will look at the firm's ability to pay day-to-day expenditure.

Once you have interpreted the meaning of the results you can then look around to consider wider issues, such as the context of the question. For example, it does not matter what size the firm's profit margin is if the economy is entering a recession and a firm sells goods that are significantly affected by changes in consumer spending. Also, you may wish to look at other non-financial factors within the firm. A highly motivated workforce may be more important for cash flow than an efficient debtors collection period.

It is important that you realise that although accounting ratios can be a very useful tool they also have many serious limitations which can render the results meaningless, or worse, can cause you to jump to incorrect conclusions.

Common limitations of ratios

Common limitations of ratios are as follows:

Not having more than one years' data. Even two years may not be enough to give a clear picture of the overall direction of the firm.
Comparisons with other firms are only meaningful if the firm's are very similar (same industry and similar size). Even firms that appear similar may have different objectives, making any comparison meaningless.
All firms will be affected by changes in the economy in different ways - this must be taken into account when analysing firm's results.
Firm's can window dress their accounts to make it look as if they are performing better than they actually are. The actual accounts and the notes to the account should be analysed to find out more about the results.
Balance sheets are drawn up on one day. If this day is not a typical day then the ratios may give a misleading picture.
Concentrating on financial data means that we may ignore important non-financial factors, such as industrial unrest, the training level of the workface and managerial problems.

The best way to avoid falling into these traps is to spend time trying to understand what the ratios actually mean. This is not just a question of learning what they should theoretically show, but rather what thinking lies behind the actual calculation of the ratio. For example, we all know that the current ratio shows us the solvency position of a firm. However, we must look into the ratio itself for it to provide meaning. A firm may have many current assets, but if these are stocks which are not very liquid then the firm may face problems. We also need to know the limitations of using a single financial statement rather than the 'whole picture'. Balance sheets are just snapshots which may have been constructed at an atypical time giving us unusual results. It is very important that ratios should be considered with the previous years' equivalent figures if any meaningful solution is to be offered.

Its is also important that the ratios were calculated in a similar way, i.e. you are treating 'like with like'. If you are engaging in comparing between two firms then it is common sense to point out that the two firms should be similar firms. In this chapter we have seen very successful firm having radically different ratios.

If you are to perform an inter-firm comparison then it is also important that the same formulas were used and that the data used was of equivalent meaning. It is also important that the accounting policies are consistent across the firms being analysed. For example, has machinery been depreciated in a more-or-less similar way such as the straight-line method?

The results that you calculate may indicate a problem which cannot be summarised through financial figures and may actually require you looking at the other areas of the firm, such as marketing or human resources. Remember, of course to take into account that the firms will be affected by the economic cycle. Firms will be affected in different ways, but all will be affected.

The best answers in ratio analysis are those that can join up the theoretical knowledge with real world factors. It is very important that you structure your answers carefully. Try to start off with the theory first before opening up to wider issues. A common format could be as follows:

Calculation of ratios.
What does the ratio tell us anyway?
What does theory tell us about our result?
Can the context of the question explain the results?
How valid are our results anyway?
What other factors should we consider?

Exam tips

There is no other way around it, you will have to learn all the formulas for the ratios - all of them!!

You can help yourself by practicing the ratios as much as possible - you will find it easier if the ratios have actually been used.

Read the question very carefully. Sometimes questions will want just a calculation and nothing else. However, it is likely that you will have to consider the scenario of the questions as well as any theoretical knowledge you have picked up through the course

The type of firm, time of year and market it operates in will all partly explain the results of the ratio calculations.

Make sure that you are looking at the appropriate category of ratio - each category will cover a slightly different aspect of the firm's overall financial position.