Ratio Analysis

Ratio Analysis

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Ratio analysis expresses relationships between financial statement line items to judge profitability, liquidity, activity, and gearing. In ICAN Accounting (3% weighting), examiners test both arithmetic calculation and interpretation of what the resulting numbers signal about a business.

Key formulas to memorise:

• Gross Profit Margin = (Gross Profit ÷ Revenue) × 100
• Net Profit Margin = (Profit after Tax ÷ Revenue) × 100
• Current Ratio = Current Assets ÷ Current Liabilities (times)
• Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities (times)
• Inventory Turnover = Cost of Sales ÷ Average Inventory (times)

High-yield pointers:

• Always pair a result with a benchmark (prior year, budget, or industry average).
• The quick ratio deliberately excludes inventory to test instant liquidity.
• Never quote a ratio without commenting on whether it improved or worsened.

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🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Classification of Ratios

ICAN examiners expect students to slot every ratio into one of four families. Misclassification is a frequent reason for losing the easy marks in a theory question.

Formula Reference Table

Ratio	Formula	What it measures
Gross Profit Margin	(Gross Profit ÷ Revenue) × 100	Pricing power and direct cost control
Net Profit Margin	(PAT ÷ Revenue) × 100	Overall profitability after all expenses
Return on Capital Employed	Operating Profit ÷ Capital Employed × 100	Efficiency of long-term capital use
Current Ratio	Current Assets ÷ Current Liabilities	Short-term solvency
Quick (Acid Test) Ratio	(Current Assets − Inventory) ÷ Current Liabilities	Immediate liquidity without stock reliance
Inventory Turnover	Cost of Sales ÷ Average Inventory	Speed of stock conversion to sales
Trade Receivable Days	(Trade Receivables ÷ Revenue) × 365	Collection efficiency in days

Interpretation Workflow

• Step 1: Compute each ratio for at least two periods (current vs prior).
• Step 2: Compare movement — state explicitly whether the ratio rose, fell, or held.
• Step 3: Link the change to a plausible business cause (rising sales, slower collections, higher gearing).
• Step 4: Cross-reference related ratios; falling liquidity alongside rising gearing often signals distress.
• Step 5: Conclude with a recommendation or risk flag.

Common Exam Traps

• Swapping cost of sales into the margin formula denominator.
• Computing ROCE using profit before interest and tax without restating capital employed.
• Quoting year-end inventory rather than the average, which inflates turnover when stock is building.

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🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Worked Micro-Example

Extract from Ndek Limited (₦ millions): Revenue 800, Cost of Sales 480, PAT 96, Current Assets 320, Inventory 120, Current Liabilities 160.

• Gross Profit Margin = (800 − 480) ÷ 800 = 40%
• Net Profit Margin = 96 ÷ 800 = 12%
• Current Ratio = 320 ÷ 160 = 2.0 times
• Quick Ratio = (320 − 120) ÷ 160 = 1.25 times
• Inventory Turnover = 480 ÷ 120 = 4.0 times

Interpretation: a 2:1 current ratio with a quick ratio above 1 suggests comfortable liquidity, while the 25 percentage-point gap between gross and net margins indicates overhead and finance costs absorb roughly half of operating profit.

Edge Cases and Limitations

• Ratios built on historical cost ignore inflation, distorting long-lived asset bases.
• Window-dressing at year-end (e.g., paying creditors just before reporting date) can flatter the current ratio without genuine improvement.
• Different accounting policies (FIFO vs weighted average) make inter-firm comparison unreliable unless disclosed.
• A single ratio is meaningless — gearing interacts with profitability through interest cover, and liquidity interacts with activity through receivables days.

Practice Prompts

1. From the statements below, compute ROCE given operating profit of ₦150m and capital employed of ₦1,000m, then critique whether the 15% result is favourable without benchmark data.
2. Discuss three limitations of ratio analysis that an ICAN candidate must mention to score full marks on a 5-mark theory question.

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