10.2 Analysis of published accounts

The current ratio compares current assets with current liabilities; the acid-test ratio excludes inventory to focus on more liquid resources. Both are snapshots of short-term coverage.

A higher ratio may indicate protection but can also show idle cash or excess stock. Interpretation needs industry, timing, credit terms and trend.

A retailer with strong current assets mainly held as seasonal inventory may look liquid on the current ratio but weaker on the acid test.

No universal ratio proves safety; asset quality and when liabilities fall due matter.

Current ratio = current assets ÷ current liabilities. Acid-test ratio = (current assets − inventory) ÷ current liabilities. Write the formula before substituting values and use the same accounting definitions.

A ratio is meaningful only when the numerator and denominator refer to the same date and reporting basis. Compare trend and context rather than chasing a memorised target.

If current assets are 120, inventory 50 and current liabilities 80, the current ratio is 1.5 and the acid test is 0.875.

A mechanically correct calculation can still mislead if receivables are doubtful or liabilities are due immediately.

Gross profit margin relates gross profit to revenue; operating profit margin relates operating profit to revenue; return on capital employed compares operating profit with capital invested.

Ratios help compare performance over time or between firms, but differences may reflect price, product mix, accounting policy, asset age or risk—not just management quality.

A firm can raise gross margin through price or lower input cost while operating margin falls because marketing and administration rise.

A higher margin is not automatically better if it depends on unsustainable price, underinvestment or lower service quality.

Gross profit margin = gross profit ÷ revenue × 100. Operating profit margin = operating profit ÷ revenue × 100. ROCE = operating profit ÷ capital employed × 100.

Write the formula and definitions first, then compare with prior periods, competitors and the business model. A ratio is a signal, not an explanation.

If gross profit is 40 and revenue 200, gross margin is 20%; if operating profit is 20, operating margin is 10%. The gap invites investigation of overheads.

Do not compare ratios with different accounting definitions or treat a higher percentage as automatically better.

Efficiency ratios such as inventory turnover, receivables days, payables days and asset turnover relate resources or working capital to sales or cost. They help identify where cash or capacity is tied up.

Interpretation requires industry, seasonality, credit terms and trend. Improving one ratio can shift risk or quality elsewhere.

Faster inventory turnover may release cash, but if stockouts increase, the apparent improvement may damage service and sales.

A ratio does not reveal the mechanism alone; investigate policy, mix, timing and data quality.

Inventory turnover relates cost of sales to average inventory; receivables and payables days relate balances to the relevant sales or purchases flow. Use average balances when the question or data require them.

A formula is meaningful only when numerator, denominator, time period and unit are consistent. State whether a result is a percentage, a turnover or days.

Receivables days of 30 means the average balance represents roughly 30 days of credit sales under the model’s assumptions; it is not a direct measure of every customer’s payment.

A mechanically correct ratio can mislead if the denominator is mismatched or seasonal.

Gearing compares long-term debt or other fixed-return finance with capital employed or equity, depending on the definition used. It signals financial risk and dependence on lenders.

Debt can magnify returns when performance is strong, but interest and repayment remain when profits fall. Interpretation needs interest cover, cash flow, asset security and industry context.

A business funding expansion mostly with debt may grow faster, but a demand shock can leave it unable to service repayments even if the assets remain valuable.

High gearing is not automatically bad and low gearing is not automatically safe; risk depends on stability and cash generation.

A gearing formula may use long-term loans ÷ capital employed × 100 or another syllabus-defined basis. Write the exact definition before substituting values and label the result.

Different definitions produce different percentages, so comparisons require the same formula, date and accounting basis.

If long-term debt is 60 and capital employed 200, the stated definition gives 30%; changing the denominator to equity would answer a different question.

A ratio is not self-explanatory: formula, period and denominator must accompany interpretation.

Investment ratios such as earnings per share, dividend yield, dividend cover and price-earnings ratio relate shareholder returns or market price to profit and dividends.

They can support comparison, but market expectations, risk, growth prospects, payout policy and one-off earnings affect interpretation.

A high P/E may reflect expected growth rather than overpricing; a high dividend yield may reflect a falling share price or an unsustainably high payout.

Ratios do not predict future returns and should not be read without the underlying earnings and dividend context.

Earnings per share divides profit available to ordinary shareholders by the number of ordinary shares. Dividend yield compares dividend per share with market price; dividend cover relates earnings to dividends.

Write the exact definition before calculating because accounting treatment, share count and timing affect the result.

A high dividend yield can arise from a generous payout or a falling share price; the same percentage can signal opportunity or risk depending on earnings and expectations.

A formula output is not an investment recommendation and cannot predict future price or dividends.