Explain and calculate the main accounting ratios for profitability, liquidity and gearing, and evaluate their use and limitations in assessing performance

What this dot point is asking

SEAB wants you to calculate and interpret the main accounting ratios - for profitability, liquidity and gearing - and to evaluate their use and limits. The central skill is interpretation: a ratio means little in isolation and only becomes informative through comparison (over time, against competitors, against benchmarks), and ratios have real limitations.

The answer

Profitability ratios

These show how well the firm turns sales and capital into profit:

• Gross profit margin $= \dfrac{\text{Gross profit}}{\text{Revenue}} \times 100$ - profit after the direct cost of sales, showing the basic profitability of the product.
• Net (operating) profit margin $= \dfrac{\text{Operating profit}}{\text{Revenue}} \times 100$ - profit after overheads too; the gap from the gross margin reflects overhead control.
• Return on capital employed (ROCE) $= \dfrac{\text{Operating profit}}{\text{Capital employed}} \times 100$ - the return generated on the capital invested; a key measure of how efficiently capital is used.

Liquidity ratios

These show the ability to meet short-term obligations:

• Current ratio $= \dfrac{\text{Current assets}}{\text{Current liabilities}}$ - around 1.5 to 2 is often comfortable; too low risks not paying bills, too high signals idle resources.
• Acid-test (quick) ratio $= \dfrac{\text{Current assets} - \text{Stock}}{\text{Current liabilities}}$ - a stricter test excluding stock (the least liquid current asset).

Gearing

• Gearing $= \dfrac{\text{Non-current liabilities (long-term debt)}}{\text{Capital employed}} \times 100$ - the proportion of capital that is debt. High gearing (often above 50%) means heavy reliance on debt and large fixed interest commitments, raising risk if profits fall; low gearing is safer but may mean the firm is not using cheap debt to grow.

Interpreting ratios: comparison is everything

A single ratio is almost meaningless. It becomes informative only relative to a benchmark:

• Trend - the firm's own ratios over time (improving or worsening?).
• Competitors and industry average - a 40% gross margin is excellent for a supermarket but poor for a luxury brand.
• The cost of capital - a 16% ROCE is attractive if borrowing costs 6%, poor if it costs 15%.

Evaluating ratio analysis: the limitations

Ratios are a powerful, quick way to assess performance and compare firms, but they have limits:

• Historic - based on past accounts, they may not reflect the current or future position.
• No qualitative factors - they ignore staff, brand, market conditions, management quality.
• Comparison pitfalls - firms use different accounting policies and operate in different industries, so comparisons can mislead.
• Window dressing - accounts can be presented to flatter ratios.
• Need context - a ratio only means something against a benchmark and a cause.

So the exam rewards calculating correctly and then interpreting through comparison while acknowledging the limits - ratios inform judgement, they do not replace it.

Examples in context

Example 1. Comparing firms within an industry. Analysts comparing two supermarket chains use ratios to see which runs more efficiently - similar gross margins but a higher net margin reveals tighter overhead control, and ROCE shows which uses its capital better. Because both operate in the same industry with similar accounting, the comparison is meaningful, illustrating that ratios shine when set against a like-for-like benchmark rather than read alone.

Example 2. Lenders and gearing in Singapore. A bank assessing a Singapore company for a loan watches gearing closely: a highly geared firm already carries heavy interest commitments, so further lending raises default risk, especially if profits are volatile. The lender reads gearing alongside liquidity (current and acid-test ratios) and profitability to judge whether the firm can service new debt - showing how stakeholders combine several ratios, in context, to reach a financing decision rather than relying on any single figure.

Try this

Q1. A firm has gross profit of \150{,}000 on revenue of \500{,}000. Calculate its gross profit margin. [2 marks]

• Cue. Gross profit margin $= \dfrac{150{,}000}{500{,}000} \times 100 = 30\%$.

Q2. Explain why a firm with a current ratio of 0.8 might be in difficulty. [4 marks]

• Cue. A current ratio of 0.8 means current assets are less than current liabilities, so the firm does not have enough short-term assets to cover the debts due within a year. This signals a liquidity problem: it may struggle to pay suppliers, staff and short-term creditors on time, risking illiquidity and, if unresolved, insolvency - even if it is trading profitably.

Q3. Analyse why ratio analysis alone is not enough to judge a company's performance. [6 marks]

• Cue. Ratios are calculated from past financial statements, so they are historic and may not reflect the current or future position, and they ignore important qualitative factors - the strength of the brand, the quality of management and staff, market conditions, and one-off events - that drive real performance. Comparisons can mislead because firms use different accounting policies and operate in different industries with different norms, and accounts can be window-dressed to flatter the figures. A ratio also only carries meaning against a benchmark and an explanation of its cause. So while ratios usefully highlight trends and prompt the right questions, a proper judgement combines them with comparison, qualitative analysis and context rather than relying on the numbers alone.