Published Accounts · Ratio Analysis · Profitability · Liquidity · Efficiency · Gearing · Limitations | Cambridge A Level Accounting 9706
Public limited companies (Plcs) are legally required to publish their financial statements annually. This ensures transparency for shareholders, lenders, creditors, employees and the public. The published accounts must follow accounting standards and include specific components.
| Component | Purpose | Key Contents |
|---|---|---|
| Statement of Profit or Loss | Show financial performance for the year | Revenue, Cost of Sales, Gross Profit, Operating Profit, Finance Costs, Tax, Profit After Tax |
| Statement of Financial Position | Show financial position at year end | Assets, Liabilities, Equity with full reserve breakdown |
| Statement of Changes in Equity | Explain movements in equity during the year | Opening equity, profit, dividends, share issues, closing equity |
| Statement of Cash Flows | Show cash movements — operating, investing, financing | Cash generated from operations, capital expenditure, financing activities |
| Notes to the Accounts | Provide detail behind the main statements | Accounting policies, NCA schedule, share capital detail, contingencies, events after reporting date |
| Directors' Report | Directors' commentary on performance and strategy | Business review, dividends paid, future plans, principal risks |
| Auditor's Report | Independent verification of financial statements | Opinion on whether accounts give a true and fair view |
Different users read published accounts for different reasons. Understanding user needs is essential for interpreting which ratios matter most to each group.
| User | Primary Interest | Most Relevant Ratios |
|---|---|---|
| Ordinary Shareholders | Return on investment, dividend income, share price growth | ROCE, EPS, Dividend per share, GP and NP margins |
| Preference Shareholders | Dividend coverage — can the company pay their fixed dividend? | Profitability ratios, interest cover |
| Debenture Holders / Banks | Security of loan, ability to pay interest | Gearing ratio, interest cover, liquidity ratios |
| Trade Suppliers (Creditors) | Will the company pay its debts on time? | Current ratio, quick ratio, payables days |
| Employees | Job security, ability to pay wages, future growth | Profitability, revenue trends, gearing |
| Government / Tax Authorities | Correct corporation tax calculation and payment | Profit before tax, effective tax rate |
| Management | Overall performance assessment, areas needing improvement | All ratios — compared to budget and prior years |
Profitability ratios measure how effectively a company generates profit from its revenue and capital. These are the most frequently examined ratios at A Level.
GPM = (Gross Profit ÷ Revenue) × 100
Expressed as a percentage. Higher is generally better. Compare year on year and with industry benchmarks.
Measures how much profit remains after paying for the cost of goods sold. A falling GPM suggests rising cost of sales, increased discounting, or a change in sales mix towards lower-margin products.
NPM = (Net Profit Before Tax ÷ Revenue) × 100
Higher is better. Compare with GPM — if GPM is stable but NPM falls, overhead expenses have increased.
Measures overall profitability after all operating expenses. The relationship between GPM and NPM is highly revealing — changes in the gap between them indicate changes in expense control.
ROCE = (Operating Profit ÷ Capital Employed) × 100
Capital Employed = Total Equity + Non-Current Liabilities
Should exceed the cost of borrowing. Compare with bank interest rate — ROCE must be higher to justify the investment risk.
The most important single measure of overall business efficiency. Uses operating profit (before interest and tax) because capital employed includes both equity and debt — we measure return before paying the providers of that capital.
ROE = (Profit After Tax ÷ Total Equity) × 100
Measures return specifically to equity shareholders. Higher gearing can inflate ROE even if ROCE is unchanged.
Useful for ordinary shareholders assessing their specific return. Differs from ROCE in that it uses profit after tax (not operating profit) and only equity (not total capital employed).
Liquidity ratios measure the ability of a company to meet its short-term obligations as they fall due. A company can be profitable but still fail if it runs out of cash.
Current Ratio = Current Assets ÷ Current Liabilities
Expressed as X : 1
Ideal range: 1.5:1 to 2:1. Below 1:1 = cannot meet short-term obligations. Above 3:1 = too much idle working capital.
For a company SFP, remember that Corporation Tax Payable and Final Dividend Payable are both current liabilities — these reduce the current ratio compared to a sole trader with the same trading position. A company's current ratio is often lower than a sole trader's for this reason.
Quick Ratio = (Current Assets − Inventories) ÷ Current Liabilities
Expressed as X : 1
Ideal: approximately 1:1. Below 0.8:1 = potential liquidity concern.
Inventories are excluded because they are the least liquid current asset — they may take time to sell and may not achieve book value in a hurry. The quick ratio tests whether liquid assets alone can cover short-term liabilities.
Efficiency ratios measure how effectively a company manages its assets and short-term obligations. They are particularly important for assessing working capital management.
Inventory Turnover = Cost of Sales ÷ Average Inventory (times per year)
Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2
OR: Inventory Days = (Closing Inventory ÷ Cost of Sales) × 365
Higher turnover (fewer days) = faster selling. Lower turnover = slow-moving or obsolete stock. Compare with industry norms.
Always use Cost of Sales — never Revenue — in the numerator. A manufacturing company may have higher inventory days than a retailer. Increasing inventory days can signal falling demand or overbuying.
Receivables Days = (Trade Receivables ÷ Credit Revenue) × 365
Should be close to the company's stated credit terms (e.g. 30 days). Rising days = poor credit control. Falling days = collecting faster (good).
Use credit revenue if given, otherwise use total revenue. If receivables days exceed credit terms, the company may have cash flow problems or weak credit control procedures.
Payables Days = (Trade Payables ÷ Credit Purchases) × 365
Should reflect the supplier credit terms. Very high days = taking too long to pay (strained supplier relationships). Very low = paying too quickly (losing free credit).
Use credit purchases if given, otherwise use Cost of Sales as an approximation. Rising payables days can indicate cash flow difficulties — the company is delaying payments to manage its cash.
Gearing = (Non-Current Liabilities ÷ Capital Employed) × 100
Capital Employed = Total Equity + Non-Current Liabilities
Below 50% = low geared. Above 50% = high geared. High gearing = higher financial risk.
Measures the proportion of long-term financing that comes from debt. Highly geared companies must pay fixed interest — this creates risk when profits fall. However, gearing can increase returns to equity shareholders when profits are high (financial leverage effect).
Interest Cover = Operating Profit ÷ Finance Costs (Debenture Interest)
Expressed as X times
Higher is safer. Below 2 times = concern. Below 1 time = cannot cover interest from operating profit — serious danger.
Measures how many times the company can pay its interest from operating profit. A company with interest cover of 5 times is much safer than one with cover of 1.5 times — even a moderate fall in profit would leave the latter unable to pay interest.
EPS = (Profit After Tax − Preference Dividend) ÷ Number of Ordinary Shares
Expressed in cents per share
Higher is better. Compare year on year — rising EPS is a positive signal for ordinary shareholders.
EPS is one of the most widely watched investor ratios. A rising EPS suggests the company is generating more profit per share — either through higher profits or share buybacks. A bonus issue dilutes EPS (more shares, same profit).
Dividend per Share = Total Ordinary Dividend ÷ Number of Ordinary Shares
Dividend Cover = EPS ÷ Dividend per Share (times)
Dividend cover of 2+ times = comfortable. Below 1 = paying out more than earned — unsustainable.
Dividend cover measures how many times the dividend could be paid from current earnings. Low dividend cover signals that the company may struggle to maintain the dividend if profits fall.
Selected financial data for Lahore Textile Plc:
| Item | 2025 ($000) | 2026 ($000) |
|---|---|---|
| Revenue | 720 | 850 |
| Gross Profit | 252 | 340 |
| Operating Profit | 180 | 230 |
| Profit Before Tax | 165 | 210 |
| Profit After Tax | 126 | 158 |
| Total Equity | 1,580 | 1,856 |
| Non-Current Liabilities (Debentures) | 200 | 200 |
| Current Assets | 175 | 200 |
| Inventories | 55 | 68 |
| Current Liabilities | 120 | 156 |
| Debenture Interest | 20 | 20 |
Calculated Ratios:
| Ratio | Formula / Working | 2025 | 2026 | Trend |
|---|---|---|---|---|
| Gross Profit Margin | (GP ÷ Revenue) × 100 | 35.0% | 40.0% | ▲ Better |
| Net Profit Margin | (PBT ÷ Revenue) × 100 | 22.9% | 24.7% | ▲ Better |
| ROCE | (Op. Profit ÷ (Equity + NCL)) × 100 | 10.1% | 11.2% | ▲ Better |
| Current Ratio | CA ÷ CL | 1.46 : 1 | 1.28 : 1 | ▼ Weaker |
| Quick Ratio | (CA − Inv) ÷ CL | 1.00 : 1 | 0.85 : 1 | ▼ Weaker |
| Gearing | (NCL ÷ (Eq + NCL)) × 100 | 11.2% | 9.7% | ▲ Less risk |
| Interest Cover | Op. Profit ÷ Finance Costs | 9.0 times | 11.5 times | ▲ Better |
Cambridge Paper 3 consistently asks candidates to evaluate the limitations of ratio analysis. Knowing the ratios is not enough — you must also be able to critically assess what ratios cannot tell us.
Ratios are calculated from past financial statements. They reflect what has already happened — not the current or future position. A company may have transformed since its last accounts were published.
Companies can manipulate year-end figures to make ratios look better — for example, delaying supplier payments to inflate the current ratio, or accelerating collections before year end. Ratios reflect one day in the year — not the typical position.
Two companies may use different depreciation methods, inventory valuation methods or capitalisation policies — making inter-company comparison unreliable even within the same industry.
There is no universally "correct" value for most ratios. What is acceptable depends on the industry, business model, economic conditions and company strategy. A current ratio of 0.8:1 may be perfectly healthy for a supermarket chain with rapid stock turnover.
Historical cost accounting means assets are recorded at their original cost — during inflation, this understates asset values and overstates ROCE. Comparing ratios across years is distorted when prices have changed significantly.
Ratios tell nothing about management quality, brand strength, customer loyalty, staff morale, product innovation, or market position — all of which may be crucial to future performance. A company with great ratios today may have serious hidden problems.
For businesses with seasonal trading patterns, the year-end position may be unrepresentative. A toy retailer's year-end liquidity position in January will look very different from its position in October before Christmas trading begins.
A single ratio for one year provides very limited information. Ratios must be compared — against prior years, industry averages, or budgeted targets — to be meaningful. Context is everything in ratio interpretation.
P-L-E-G
Profitability — GPM, NPM, ROCE, ROE
Liquidity — Current Ratio, Quick Ratio
Efficiency — Inventory Days, Receivables Days, Payables Days
Gearing — Gearing Ratio, Interest Cover, EPS, Dividend Cover
Capital Employed includes both equity and debt (debentures).
We measure return before paying interest and tax — so we use
Operating Profit.
If we used profit after tax, we would have already deducted the interest
paid to debt holders — unfair when debt is part of capital employed.
Question 1 Knowledge — 2 marks Paper 1
Explain why operating profit is used in the ROCE formula rather than profit after tax.
Capital employed includes both equity and long-term debt (debentures). Both equity holders and debt holders have provided capital to the business. (1 mark)
Operating profit is measured before deducting interest — so it represents the return generated by the business before paying either group of capital providers. Using profit after tax (which has already deducted interest) would give an inconsistent result — we would have deducted the return paid to debt holders from the numerator while still including debt in the denominator. (1 mark)
Question 2 Application — 8 marks Paper 3
The following data relates to Karachi Steel Plc:
| Item | 2025 ($000) | 2026 ($000) |
|---|---|---|
| Revenue | 1,100 | 1,200 |
| Cost of Sales | 660 | 720 |
| Operating Profit | 275 | 320 |
| Finance Costs (interest) | 30 | 30 |
| Total Equity | 1,600 | 1,700 |
| Non-Current Liabilities | 300 | 300 |
| Closing Inventory | 88 | 120 |
| Trade Receivables | 110 | 160 |
| Current Assets | 240 | 320 |
| Current Liabilities | 140 | 185 |
Calculate for both years: GPM, ROCE, Current Ratio, Inventory Days, Receivables Days. Comment on the overall performance and financial position of Karachi Steel Plc.
| Ratio | 2025 | 2026 | Trend |
|---|---|---|---|
| GPM: (GP ÷ Rev) × 100 GP = Rev − CoS |
40.0% (440÷1100)×100 |
40.0% (480÷1200)×100 |
→ Stable |
| ROCE: (Op.P ÷ (Eq+NCL)) × 100 | 14.5% 275÷1900×100 |
16.0% 320÷2000×100 |
▲ Better |
| Current Ratio: CA ÷ CL | 1.71 : 1 | 1.73 : 1 | ▲ Stable/Slight improvement |
| Inventory Days: (Inv ÷ CoS) × 365 | 48.7 days (88÷660)×365 |
60.8 days (120÷720)×365 |
▼ Worse |
| Receivables Days: (Rec ÷ Rev) × 365 | 36.5 days (110÷1100)×365 |
48.7 days (160÷1200)×365 |
▼ Worse |
Comment: Karachi Steel Plc has maintained a stable gross profit margin of 40% in both years, indicating consistent cost of sales control despite revenue growth. ROCE improved from 14.5% to 16.0% — the company is generating a better return on its capital base, a positive signal for investors. Liquidity remains comfortable with a current ratio close to the ideal range in both years.
However, two efficiency ratios show deterioration. Inventory days increased from 48.7 to 60.8 days — stock is being held for longer, which may indicate slowing demand or overbuying. Receivables days increased from 36.5 to 48.7 days — customers are taking longer to pay, which could create cash flow pressure despite the healthy current ratio. Management should review credit control procedures and inventory purchasing.
(4 marks for calculations + 4 marks for interpretation)Question 3 Analysis — 4 marks Paper 3
Discuss four limitations of using ratio analysis to assess the performance of a limited company.
Any four of the following (1 mark each):
Question 4 Analysis — 3 marks Paper 1
A company's gearing ratio increased from 28% to 47% following a new debenture issue. Explain two risks and one benefit of this increase in gearing.
Risk 1: Debenture interest must be paid regardless of profit levels — the company now has a larger fixed financial commitment. If profits fall, the company may struggle to service its debt, increasing the risk of financial distress. (1 mark)
Risk 2: Higher gearing makes the company less attractive to further lenders and may make it harder or more expensive to raise additional debt finance in the future. Existing lenders may impose restrictive covenants. (1 mark)
Benefit: Debenture interest is tax-deductible — it reduces the company's taxable profit. Additionally, if the funds raised generate a return higher than the cost of borrowing, this financial leverage will increase the return available to ordinary shareholders (EPS and ROE both improve). (1 mark)
Question 5 Analysis — 3 marks Paper 3
Explain why a supermarket chain might be expected to have a lower current ratio than a manufacturing company, and why this does not necessarily indicate a liquidity problem.
A supermarket sells goods for cash immediately — it has minimal or zero trade receivables. It also negotiates long credit terms with suppliers, resulting in large trade payables. These two factors push the current ratio down: receivables (a current asset) are very low, while payables (a current liability) are very high. (1 mark)
A manufacturing company, by contrast, sells goods on credit (creating trade receivables) and holds significant work-in-progress and raw material inventories — both of which are current assets. This naturally results in a higher current ratio. (1 mark)
A supermarket's low current ratio does not indicate a liquidity problem because it has very high inventory turnover — stock converts to cash very rapidly (often within days). The company receives cash from customers before it must pay its suppliers, giving it a positive cash conversion cycle despite a low current ratio. Context and business model are essential when interpreting ratios. (1 mark)