Master Financial Performance Analysis

GCSE • A-Level • AQA • Edexcel • OCR

 

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Profitability Ratios

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Ratio

Formula

What it Measures

Good Sign

Poor Sign

Gross Profit Margin

Gross Profit ÷ Revenue × 100

Efficiency of production and pricing

Increasing

Falling margins

Operating Profit Margin

Operating Profit ÷ Revenue × 100

Overall operational efficiency

Higher than competitors

Rising costs reducing profit

Profit for the Year Margin (Net Profit Margin)

Profit for the Year ÷ Revenue × 100

Final profitability after all expenses

Increasing over time

Falling profitability

Examiner Tip

Always explain why the ratio changed.

Instead of:

Gross profit increased.

Write:

Gross profit margin increased from 38% to 44%, suggesting improved cost control or greater pricing power, which should strengthen profitability if maintained.

Liquidity Ratios

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Ratio

Formula

Ideal Range

What it Shows

Current Ratio

Current Assets ÷ Current Liabilities

1.2–2.0

Ability to pay short-term debts

Acid Test Ratio

(Current Assets − Inventory) ÷ Current Liabilities

Around 1

Immediate liquidity excluding stock

Interpretation

High Current Ratio

✓ Good liquidity

✗ Too much idle cash

Low Current Ratio

✓ Efficient working capital

✗ Possible cash flow problems

Efficiency Ratios

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Ratio

Formula

Better Direction

Inventory Turnover

Cost of Sales ÷ Average Inventory

Higher generally better

Inventory Turnover Period

Average Inventory ÷ Cost of Sales × 365

Lower generally better

Receivables Days

Trade Receivables ÷ Revenue × 365

Lower

Payables Days

Trade Payables ÷ Cost of Sales × 365

Higher (within supplier terms)

Asset Turnover

Revenue ÷ Capital Employed

Higher

What They Mean

Inventory too high

↓

Cash tied up

↓

Higher storage costs

↓

Lower profitability

Receivables too high

↓

Customers paying late

↓

Poor cash flow

↓

Potential bad debts

Payables increasing

↓

Improves cash flow

BUT

↓

May damage supplier relationships

Investment Ratios

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Ratio

Formula

Interpretation

Return on Capital Employed (ROCE)

Operating Profit ÷ Capital Employed × 100

Overall efficiency of invested capital

ROCE Analysis

High ROCE

✓ Business using assets efficiently

✓ Strong investment performance

Low ROCE

✗ Weak returns

✗ Possible overinvestment

Financial Ratio Comparison

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Ratio Type

Measures

Profitability

Profit generation

Liquidity

Ability to pay debts

Efficiency

Use of resources

Investment

Return to investors

Examiner Analysis Framework

Never stop at calculating the ratio.

Use this structure:

Step 1

State the figure.

ROCE increased from 12% to 17%.

↓

Step 2

Interpret.

This suggests capital is being used more efficiently.

↓

Step 3

Explain why.

The business may have increased sales while controlling operating costs.

↓

Step 4

Evaluate.

However, this may only be temporary if demand falls next year.

This four-step structure is what earns higher-level analysis marks.

Common Evaluation Points

Every ratio has limitations.

Always consider:

✓ Industry averages

✓ Previous years

✓ Competitor performance

✓ Economic conditions

✓ Seasonal effects

✓ One-off events

Common Exam Mistakes

❌ Calculating but not interpreting

❌ Ignoring trends

❌ Comparing unrelated industries

❌ No judgement

❌ Confusing liquidity with profitability

❌ Using the wrong denominator

❌ Forgetting percentages

Ratio Memory Tricks

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Ratio

Remember

Gross Margin

Production efficiency

Operating Margin

Running the business

Current Ratio

Can we pay today’s bills?

Acid Test

Can we pay immediately?

ROCE

Are investors getting good returns?

Receivables Days

How quickly customers pay

Payables Days

How long we take to pay suppliers

Inventory Turnover

How quickly stock sells

30-Second Exam Checklist

Before moving on, ask yourself:

☐ Have I calculated the ratio correctly?

☐ Have I interpreted it?

☐ Have I explained the reason?

☐ Have I linked it to the case study?

☐ Have I evaluated the result?

☐ Have I reached a judgement?