Ratio analysis — Edexcel A-Level Business
Test yourself on Ratio analysis with PEARSON EDEXCEL A-Level practice questions.
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Ratio analysis explained
Two percentage figures built on the same denominator, capital employed, which is total equity plus non-current liabilities.
Read the full explanation
The first is non-current liabilities over capital employed as a percentage, measuring reliance on borrowed money: above fifty per cent is conventionally called highly geared, cheap while interest rates are low and dangerous when they rise or sales fall, because interest must be paid whatever happens to demand. The second is operating profit over capital employed as a percentage, the single best test of how hard the money invested is working, and it is judged against last year, against rivals and against the cost of borrowing. If operating profit is 1.2 million pounds on capital employed of 8 million pounds, the return is fifteen per cent, which beats a loan costing six per cent.
b) Interpret ratios to make business decisions
A ratio on its own means nothing; it acquires meaning only against a comparison, and the four a marker looks for are the previous year, a close competitor, the industry norm and the firm's own target. Match the measure to the question being asked: profitability through return on capital employed and the margins, liquidity through the current and acid test ratios, financial risk through the borrowing figure, efficiency through inventory turnover and receivable days. Then say what the business should do about it, because the credit is for the decision rather than the arithmetic. A falling return alongside rising revenue points at cost control rather than demand; a current ratio far above the sector norm is idle cash that could be invested; heavy existing borrowing argues for a rights issue rather than another loan.
c) The limitations of ratio analysis
Every one of these figures comes from published accounts, which are historic, summarised and prepared under policies the directors chose, so the number describes a year that has ended rather than the one the decision concerns. Comparison between firms is weakened because depreciation methods, inventory valuation and the treatment of leases differ, and a company can window dress by chasing payments and settling payables just before the year end to flatter liquidity. Nothing in the arithmetic captures the quality of management, the strength of the brand, staff morale, a pending lawsuit or a shift in the market, and inflation quietly distorts any comparison across several years. The honest conclusion is not that the technique is useless but that it raises the right questions and needs qualitative evidence before a board acts.
Your focus
- a) Calculate: Gearing ratio; Return on capital employed (ROCE)
- b) Interpret ratios to make business decisions
- c) The limitations of ratio analysis
Ratio analysis exam tips
Marking Points
- Building capital employed correctly as total equity plus non-current liabilities, or equivalently as total assets minus current liabilities.
- Using operating profit rather than profit for the year in the return calculation, because the return must be measured before the cost of the finance being appraised.
- Expressing both answers as percentages to one decimal place with the units shown, and carrying the correct figures through from the extract.
- Interpreting the borrowing figure as risk, explaining that a highly geared firm faces fixed interest obligations that bite hardest when revenue falls.
- Comparing the return against a benchmark, whether the previous year, a competitor or the interest rate on new borrowing, rather than calling a number good in isolation.
- Quoting the calculated figure and immediately naming the comparator, so the interpretation rests on a change or a gap rather than on the number alone.
- Chaining two ratios together to build a diagnosis, for example a stable gross margin with a falling operating margin isolating overheads as the problem.
- Translating the number into a management action, such as extending supplier credit terms, discounting obsolete inventory or postponing an expansion.
- Weighting the ratios by what the decision needs, so a lender prioritises borrowing and liquidity while a potential investor prioritises the return on capital employed.
- Acknowledging that the ratio reports a symptom and naming the possible causes, since the same movement can arise from price, volume or cost.
- Naming a specific limitation and attaching it to the specific ratio used in the case, such as historic figures undermining a liquidity judgement made months later.
- Explaining window dressing as a mechanism, showing how timing a payment or a sale around the year end changes the reported position without changing the business.
- Pointing out that different accounting policies make cross company comparison unreliable, so a rival's apparently better return may reflect a different depreciation choice.
- Bringing in the qualitative factors the figures omit, including management quality, brand strength, employee relations and the competitive environment.
- Reaching a balanced judgement that the ratios remain the starting point for investigation, and saying what further evidence would settle the decision.
Examiner Tips
- 💡Calculate questions carry four marks and the method marks are recoverable, so write the formula, then the substitution, then the answer with a percentage sign.
- 💡The calculation is almost always followed by an assess or evaluate question using your own figure, so keep the workings visible to quote from.
- 💡If the extract gives two years, work both and talk about the direction of travel, because a trend argues more strongly than a single number.
- 💡Write the sentence pattern the markers reward: the figure, the comparison, the likely cause, the consequence for this business, then the action.
- 💡In a twenty mark evaluation, use two ratios that disagree with each other, because a tension is what a supported judgement resolves.
- 💡Finish by naming the extra information you would want, such as the competitor's accounts or the order book, which signals awareness of the evidence's limits.
- 💡This is the evaluation half of almost every financial question, so bank two limitations that genuinely bite on the case rather than reciting five.
- 💡Tie the limitation to the size of the decision, since a small reorder needs less certainty than a takeover bid.
- 💡Name one extra piece of evidence you would ask for, such as a cash flow forecast or the order book, because that converts criticism into a supported recommendation.
Common Mistakes
- Putting total liabilities, including trade payables and overdrafts, into the borrowing figure, which overstates long term reliance on debt.
- Using profit for the year after interest and tax in the return calculation, which double counts the cost of the very capital being measured.
- Forgetting to multiply by one hundred, so the answer is reported as a small decimal and loses the interpretation marks that follow.
- Declaring high borrowing automatically bad without considering that debt is cheaper than equity and avoids diluting existing shareholders.
- Describing the number in words, saying the current ratio has risen, and stopping there, which is description and not interpretation.
- Applying ideal values from a textbook to any business regardless of sector, so a retailer with fast stock turnover and no receivables is judged illiquid.
- Ignoring the size of the change, treating a movement of a fraction of a percentage point as significant evidence.
- Recommending an action with no link to the figure calculated, so the decision floats free of the financial evidence in the extract.
- Writing that accounts can be manipulated, without naming a mechanism such as timing payables or revaluing assets, which leaves the point unsupported.
- Rejecting the technique entirely, which ignores that lenders and investors use it every day and loses the balance the top band requires.
- Repeating the limitations as a memorised list with no reference to the business in the extract or to the ratio actually calculated.
- Confusing a limitation of the data with a limitation of the method, for example blaming the current ratio for the fact that the accounts are a year old.