Calculation and understanding of accounting ratios

1. Gross Profit Margin
Measures the profit made on each dollar of sales after covering the direct cost of goods sold.

\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100

• Gross Profit: Revenue minus Cost of Sales.
• Revenue: Total sales value.
• Result: Expressed as a percentage (%).

2. Mark-up
Measures the profit added to the cost price. It is often used in retail pricing.

\text{Mark-up} = \frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100

• Note: Mark-up is based on cost, whereas Gross Margin is based on revenue. Therefore, Mark-up will always be a higher percentage than Gross Margin for the same business.

3. Profit Margin (Net Profit Margin)
Measures the final profit after ALL expenses (operating costs, interest, tax) have been paid.

\text{Profit Margin} = \frac{\text{Net Profit}}{\text{Revenue}} \times 100

• Net Profit: The bottom line of the Statement of Profit or Loss.

4. Return on Capital Employed (ROCE)
Measures how efficiently the business uses its long-term capital to generate profit. This is a key measure of overall efficiency.

\text{ROCE} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100

• Operating Profit: Profit before interest and tax (often called EBIT).
• Capital Employed: Total Assets minus Non-Current Liabilities. Alternatively, Equity plus Non-Current Liabilities.
• Result: Expressed as a percentage (%).

5. Current (Working Capital) Ratio
Measures the ability to pay short-term debts with all current assets.

\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

• Result: Expressed as a ratio, e.g., 2:1.
• Interpretation: A ratio of 1.5:1 to 2:1 is generally considered healthy. Below 1:1 suggests liquidity problems.

6. Acid Test (Liquid) Ratio
A stricter test of liquidity. It removes inventory because stock is not always easy to convert into cash quickly.

\text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}

• Numerator: Sometimes called 'Liquid Assets' or 'Quick Assets'.
• Result: Expressed as a ratio, e.g., 0.8:1.
• Interpretation: A ratio of 1:1 is often considered the benchmark for adequacy.

Important Note on Credit vs. Cash: In Cambridge exams, if a question gives 'Revenue' or 'Purchases' without specifying cash/credit splits for turnover ratios, you must assume all sales are on credit and all purchases are on credit unless told otherwise.

7. Rate of Inventory Turnover (Times)
Measures how many times inventory is sold and replaced over a period.

\text{Inventory Turnover (Times)} = \frac{\text{Cost of Sales}}{\text{Average Inventory}}

• Average Inventory: (\text{Opening Inventory} + \text{Closing Inventory}) / 2.
• Result: Expressed in 'times'.

8. Inventory Turnover (Days)
Measures the average number of days inventory is held before being sold.

\text{Inventory Holding Period (Days)} = \frac{\text{Average Inventory}}{\text{Cost of Sales}} \times 365

• Result: Expressed in 'days'.

9. Trade Receivables Turnover (Days)
Measures the average number of days it takes to collect cash from customers.

\text{Receivables Collection Period (Days)} = \frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365

• Note: Use Credit Sales only. If only 'Revenue' is given, assume it is all credit.
• Result: Expressed in 'days'.

10. Trade Payables Turnover (Days)
Measures the average number of days the business takes to pay its suppliers.

\text{Payables Payment Period (Days)} = \frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365

• Note: Use Credit Purchases. If 'Purchases' is given without a cash/credit split, assume it is all credit.
• Result: Expressed in 'days'.

Trade Payables Turnover (Times)
Sometimes asked as the inverse of the days ratio:

\text{Payables Turnover (Times)} = \frac{\text{Credit Purchases}}{\text{Average Trade Payables}}