3.5 Accounts analysis
- Syllabus
- 2026
- Topic
- 3.5
- Level
- —
Learning objectives
3.5.1Calculating and analysing accounting ratiosCalculate and analyse gross profit margin, operating profit margin, markup, return on capital employed (ROCE), current ratio and acid test ratio. Use gross profit = revenue − cost of sales; operating profit = gross profit − other operating expenses; gross profit margin = gross profit ÷ revenue × 100; operating profit margin = operating profit ÷ revenue × 100; markup = profit per item ÷ cost per item × 100; ROCE = operating profit ÷ capital employed × 100; current ratio = current assets ÷ current liabilities; acid test ratio = (current assets − inventory) ÷ current liabilities. The examination provides these formulae.3.5.2LiquidityLiquidity:• the concept and importance of liquidity• comparisons with previous years and/or with other business organisations.3.5.3Use of financial documentsThe use of financial documents:• assess the performance of the business• inform decision making.
Calculate each ratio, then explain what changed
Accounting ratios turn financial-statement figures into comparable measures. First identify the ratio, select figures from the same business and period, calculate with the correct denominator, and state the unit. Then compare and explain the business reason for the difference.
grossprofit=revenue−costofsales;operatingprofit=grossprofit−otheroperatingexpenses
| Ratio | Calculation | What it measures | Unit |
|---|---|---|---|
| gross profit margin | gross profit ÷ revenue × 100 | profit after cost of sales from each 100 of revenue | % |
| operating profit margin | operating profit ÷ revenue × 100 | profit after operating expenses from each 100 of revenue | % |
| markup | profit per item ÷ cost per item × 100 | profit added relative to item cost | % |
| ROCE | operating profit ÷ capital employed × 100 | operating return generated by long-term capital | % |
| current ratio | current assets ÷ current liabilities | short-term asset cover for short-term debts | ratio, for example 1.50:1 |
| acid test ratio | (current assets − inventory) ÷ current liabilities | short-term cover without relying on inventory | ratio, for example 0.90:1 |
| Evidence | Calculation | Result | Initial reading |
|---|---|---|---|
| revenue £90,000; gross profit £22,000; expenses £4,000 | operating profit = 22,000 − 4,000 | £18,000 | amount left after operating expenses |
| operating profit £18,000; revenue £90,000 | 18,000 ÷ 90,000 × 100 | 20% | £20 operating profit per £100 revenue |
| operating profit £60,000; capital employed £80,000 | 60,000 ÷ 80,000 × 100 | 75% | £75 operating return per £100 capital employed |
A rise in a margin or ROCE may indicate stronger cost control, pricing or use of capital; a fall may reflect higher input costs, discounting, overheads or investment not yet producing returns. Test the explanation against the underlying figures and compare with previous years or a similar business.
Do not confuse markup with profit margin: markup divides by cost, while a margin divides by revenue. A higher ratio is not automatically better, and ratios with different definitions, periods, currencies or business models are not directly comparable.
Judge liquidity through trend, context and asset quality
Liquidity is a business's ability to meet short-term obligations when they fall due. A profitable business can still fail if cash and other liquid current assets are unavailable when suppliers, wages or tax must be paid.
currentratio=currentassets/currentliabilities;acidtestratio=(currentassets−inventory)/currentliabilities
| Evidence | Useful interpretation | What to check next |
|---|---|---|
| acid test rises from 0.75 to 0.88 | liquid-asset cover has improved, but remains below one unit per unit of current liabilities | cash-flow timing, access to short-term finance and whether creditors are due before customers pay |
| current ratio is much higher than acid test | inventory forms a large share of current assets | how quickly and reliably inventory can be sold without heavy discounting |
| ratio falls against last year or a similar competitor | short-term payment risk may have increased | whether this reflects deliberate working-capital choices, seasonality or unusual liabilities |
Liquidity supports continuous trading: the business can pay urgent bills, retain supplier confidence and avoid emergency borrowing or asset sales. Managers can improve it by collecting receivables sooner, controlling inventory, negotiating payment timing or arranging suitable finance—but each action has costs and operational effects.
Make like-for-like comparisons over several years and with similar organisations. Explain both the direction and size of change, then connect it to the business's inventory cycle, customer-credit terms, seasonal cash flows and reliability of finance.
There is no universal ideal liquidity ratio. A very low ratio can signal payment risk, but a very high ratio may reflect idle cash, slow inventory or uncollected receivables. A ratio is a snapshot and does not show exactly when cash receipts and payments occur.
Turn financial documents into a reasoned decision
Financial documents help a business assess past performance and inform future decisions. Use a chain: identify relevant evidence, calculate or compare it, explain the business cause or consequence, and weigh it with other evidence before deciding.
| Financial evidence | Performance question | Possible decision informed |
|---|---|---|
| revenue, gross profit and operating profit over time | are sales growing, and is growth becoming profit after costs? | pricing, promotion, supplier choice and operating-cost control |
| margins and ROCE against previous years or competitors | is efficiency or return improving on a comparable basis? | investment, expansion, closure or allocation of capital |
| current assets, current liabilities and liquidity ratios | can short-term obligations be met without disruption? | inventory, customer credit, supplier terms and short-term finance |
| several years of profit, position and liquidity | can the business afford and repay borrowing? | lender approval, loan size, interest terms and security |
Example: if revenue rises but operating profit margin falls, sales growth alone does not prove stronger performance. Operating expenses or cost pressures may have grown faster than revenue. Managers could investigate costs before expanding; a lender would also examine liquidity, cash-flow timing and the multi-year pattern before judging repayment risk.
Managers use the evidence to plan and control; owners and shareholders judge return and risk; lenders assess repayment capacity; suppliers may consider creditworthiness. The same figure matters differently to each user, so the conclusion must match the decision being made.
Accounts are mainly historic and a statement of financial position is a snapshot. Accounting choices, inflation, one-off events and different business models can distort comparisons, while finance alone omits demand, competition, workforce capability and strategic fit. Use several documents, ratios, periods and non-financial evidence.