Profitability, Liquidity, Efficiency & Investment Ratios | Cambridge O Level Accounting 7707
Financial statements contain a great deal of information — but raw figures alone can be misleading. A business with a profit of $50,000 may sound impressive, but is that good or bad? Without context, we cannot judge. Ratio analysis converts financial figures into meaningful relationships that allow comparison over time or against other businesses.
Measure how effectively the business generates profit from its revenue and resources.
Gross Profit Margin, Net Profit Margin, Return on Capital Employed
Measure the ability of the business to meet its short-term obligations.
Current Ratio, Quick Ratio (Acid Test)
Measure how efficiently the business manages its assets and liabilities.
Inventory Turnover, Trade Receivables Days, Trade Payables Days
Assess returns to owners and the capital structure of the business.
Return on Equity, Gearing (where applicable)
The following extracts from the financial statements of Zara Trading Co. are used for all ratio calculations in this lesson.
Opening Inventory (1 Jan 2026) = $14,000 | Credit Sales = $160,000 | Credit Purchases = $110,000
GP Margin = (Gross Profit ÷ Revenue) × 100
What it measures: The percentage of each dollar of sales retained
as gross profit after paying for the cost of goods sold.
Calculation: (60,000 ÷ 200,000) × 100 = 30%
Interpretation: For every $1 of sales, 30 cents is gross profit.
A higher % is better. A fall may indicate rising costs of purchases, increased
competition forcing price cuts, or higher carriage inwards.
NP Margin = (Net Profit ÷ Revenue) × 100
What it measures: The percentage of each dollar of sales retained
as net profit after all expenses.
Calculation: (24,000 ÷ 200,000) × 100 = 12%
Interpretation: If GP margin is stable but NP margin falls,
expenses have increased relative to sales. If both fall, cost of sales has risen.
Compare with GP margin to isolate the problem.
ROCE = (Net Profit ÷ Capital Employed) × 100
What it measures: How efficiently the business generates profit
from the total long-term funds invested (capital + long-term loans).
Calculation: (24,000 ÷ 120,000) × 100 = 20%
Interpretation: A 20% ROCE means every $100 invested generates $20
net profit. Compare with the bank interest rate — if ROCE < interest rate,
investors would be better off putting money in the bank.
Current Ratio = Current Assets ÷ Current Liabilities
What it measures: Whether the business has enough current assets
to cover its current liabilities — its short-term solvency.
Calculation: 45,000 ÷ 18,000 = 2.5 : 1
Ideal range: Approximately 1.5 : 1 to 2 : 1
Interpretation: Too low (<1) = cannot pay short-term debts
(liquidity crisis). Too high (>3) = too much cash or inventory tied up
unproductively (poor asset management). This ratio does not tell us how quickly
assets can be converted to cash.
Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities
What it measures: A stricter liquidity test that excludes inventory
(the least liquid current asset) — can the business pay debts from liquid assets alone?
Calculation: (45,000 − 18,000) ÷ 18,000 = 27,000 ÷ 18,000 =
1.5 : 1
Ideal range: Approximately 1 : 1
Interpretation: A ratio below 1:1 means the business cannot meet
current liabilities from liquid assets alone — potential cash flow problem.
Inventory is excluded because it may take time to sell and convert to cash.
Inventory Turnover = Cost of Sales ÷ Average Inventory (times per year)
Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2
What it measures: How many times inventory is sold and replaced
during the year.
Calculation: Average Inventory = (14,000 + 18,000) ÷ 2 = $16,000
Inventory Turnover = 140,000 ÷ 16,000 = 8.75 times
Interpretation: Higher turnover = inventory sold quickly (good for
perishable goods). Lower turnover = slow-moving stock (risk of obsolescence or
overstocking). Compare with industry average — a supermarket turns over much faster
than a furniture retailer.
Inventory Days = (Average Inventory ÷ Cost of Sales) × 365
What it measures: The average number of days inventory is held
before being sold.
Calculation: (16,000 ÷ 140,000) × 365 = 41.7 days
Interpretation: Inventory is held for about 42 days on average.
Fewer days = faster selling. More days = slower selling or overstocking.
Receivables Days = (Trade Receivables ÷ Credit Sales) × 365
What it measures: The average number of days it takes to collect
payment from credit customers.
Calculation: (22,000 ÷ 160,000) × 365 = 50.2 days
Interpretation: Customers take about 50 days to pay. If the credit
terms are 30 days, this is too slow — the business is not collecting debts
efficiently. Fewer days = better cash flow.
Payables Days = (Trade Payables ÷ Credit Purchases) × 365
What it measures: The average number of days the business takes
to pay its suppliers.
Calculation: (15,000 ÷ 110,000) × 365 = 49.8 days
Interpretation: The business takes about 50 days to pay suppliers.
More days = business is using suppliers as a source of free finance (good for cash
flow but may damage supplier relationships). Fewer days = paying too quickly,
possibly missing out on credit terms.
| Ratio | Formula | Result (Zara 2026) | Ideal / Benchmark |
|---|---|---|---|
| GP Margin | (GP ÷ Revenue) × 100 | 30% | Depends on industry |
| NP Margin | (NP ÷ Revenue) × 100 | 12% | Depends on industry |
| ROCE | (NP ÷ Capital Employed) × 100 | 20% | Above bank interest rate |
| Current Ratio | Current Assets ÷ Current Liabilities | 2.5 : 1 | 1.5 : 1 to 2 : 1 |
| Quick Ratio | (CA − Inventory) ÷ CL | 1.5 : 1 | ≈ 1 : 1 |
| Inventory Turnover | CoS ÷ Average Inventory | 8.75 times | Higher = better |
| Inventory Days | (Avg Inv ÷ CoS) × 365 | 41.7 days | Lower = better |
| Receivables Days | (Receivables ÷ Credit Sales) × 365 | 50.2 days | Lower = better / within terms |
| Payables Days | (Payables ÷ Credit Purchases) × 365 | 49.8 days | Within supplier terms |
Calculating a ratio earns marks — but interpreting it earns even more. The examiner expects a structured comment that includes: the ratio value, what it means, whether it is good or bad, a possible reason for any change, and a recommendation if asked.
Compare Year 1 and Year 2 data for Bilal Traders:
| Ratio | Year 1 | Year 2 | Change |
|---|---|---|---|
| GP Margin | 35% | 28% | ↓ 7% |
| NP Margin | 18% | 19% | ↑ 1% |
| Current Ratio | 1.8 : 1 | 0.9 : 1 | ↓ 0.9 |
| Quick Ratio | 1.2 : 1 | 0.5 : 1 | ↓ 0.7 |
| Limitation | Explanation |
|---|---|
| Historical data | Ratios are based on past financial statements — they do not predict future performance. |
| Different accounting policies | Two businesses may use different depreciation methods or inventory valuation — ratios are not directly comparable. |
| Inflation | Changes in price levels can distort year-on-year comparisons — a rise in revenue may reflect inflation, not real growth. |
| Seasonal businesses | A year-end snapshot may not reflect the typical position — a retailer at 31 December may have unusually high inventory. |
| No qualitative factors | Ratios ignore non-financial information such as staff morale, brand reputation, market conditions or customer satisfaction. |
| Window dressing | Management may manipulate year-end figures (e.g. delay payments to creditors) to make ratios look better than they really are. |
| No single "correct" benchmark | Ideal ratios vary by industry — a 2:1 current ratio may be excellent for one business and dangerously high for another. |
GP Margin: GP on Sales — "GS"
NP Margin: NP on Sales — "NS"
ROCE: NP on Capital — "NC"
All three are expressed as percentages (× 100).
Current Ratio: All Current Assets ÷ Current Liabilities → ideal ~2:1
Quick Ratio: (CA − Inventory) ÷ CL → ideal ~1:1
Quick removes Inventory because it is the least liquid current asset.
Receivables Days → use Credit Sales (not total sales)
Payables Days → use Credit Purchases (not total purchases)
Inventory Days → use Cost of Sales (not revenue)
All days ratios: divide by the relevant annual figure, then multiply by 365.
Question 1 Knowledge — 2 marks
Explain the difference between the current ratio and the quick ratio and state why inventory is excluded from the quick ratio.
The current ratio measures a business's ability to meet its short-term liabilities using all current assets (including inventory). The quick ratio is a stricter measure that excludes inventory from current assets. (1 mark)
Inventory is excluded from the quick ratio because it is the least liquid current asset — it may take time to sell and convert into cash, and may not always be sold at full value. The quick ratio therefore gives a more conservative view of immediate liquidity. (1 mark)
Question 2 Application — 6 marks
Using the following information, calculate five ratios for Hassan Traders for the year ended 31 December 2026:
| Item | $ |
|---|---|
| Sales Revenue | 150,000 |
| Credit Sales | 120,000 |
| Cost of Sales | 90,000 |
| Gross Profit | 60,000 |
| Net Profit | 18,000 |
| Capital Employed | 100,000 |
| Current Assets | 40,000 |
| Inventory | 16,000 |
| Trade Receivables | 20,000 |
| Current Liabilities | 20,000 |
Calculate: GP Margin, NP Margin, ROCE, Current Ratio, Quick Ratio.
| Ratio | Working | Result |
|---|---|---|
| GP Margin | (60,000 ÷ 150,000) × 100 | 40% |
| NP Margin | (18,000 ÷ 150,000) × 100 | 12% |
| ROCE | (18,000 ÷ 100,000) × 100 | 18% |
| Current Ratio | 40,000 ÷ 20,000 | 2.0 : 1 |
| Quick Ratio | (40,000 − 16,000) ÷ 20,000 | 1.2 : 1 |
Question 3 Application — 4 marks
Calculate the Receivables Days, Payables Days and Inventory Turnover for the following business:
| Item | $ |
|---|---|
| Credit Sales | 180,000 |
| Credit Purchases | 130,000 |
| Cost of Sales | 126,000 |
| Trade Receivables | 25,000 |
| Trade Payables | 18,000 |
| Opening Inventory | 20,000 |
| Closing Inventory | 16,000 |
| Ratio | Working | Result |
|---|---|---|
| Receivables Days | (25,000 ÷ 180,000) × 365 | 50.7 days |
| Payables Days | (18,000 ÷ 130,000) × 365 | 50.5 days |
| Avg Inventory | (20,000 + 16,000) ÷ 2 | $18,000 |
| Inventory Turnover | 126,000 ÷ 18,000 | 7 times |
Question 4 Analysis — 5 marks
The following ratios have been calculated for a business over two years:
| Ratio | Year 1 | Year 2 |
|---|---|---|
| GP Margin | 40% | 32% |
| NP Margin | 15% | 18% |
| Current Ratio | 2.2 : 1 | 1.4 : 1 |
| Receivables Days | 35 days | 55 days |
Interpret these ratios and advise the business owner on areas of concern.
GP Margin (40% → 32%): The gross profit margin has fallen sharply by 8 percentage points. This is a significant concern — the cost of sales is consuming a larger proportion of revenue. Possible causes include increased purchase costs, discounting of selling prices, or rising carriage inwards. The owner should review supplier contracts and pricing strategy. (1–2 marks)
NP Margin (15% → 18%): Despite the falling gross profit margin, the net profit margin has actually improved. This suggests the owner has cut expenses significantly — the saving in expenses has more than compensated for the lower gross profit. This reflects good cost control. (1 mark)
Current Ratio (2.2 → 1.4): The current ratio has fallen but remains above 1:1, so the business can still meet short-term obligations. However, the decline is worth monitoring — if it continues, liquidity may become a problem. (1 mark)
Receivables Days (35 → 55 days): Customers are taking significantly longer to pay — an extra 20 days on average. This is a serious concern as it damages cash flow. The owner should tighten credit control, send reminders earlier, and consider offering early payment discounts to speed up collections. (1 mark)
Question 5 Analysis — 3 marks
State three limitations of using ratio analysis to assess the performance of a business.
Any three of the following (1 mark each):