Analysis of
Accounts
Profitability ratios (GPM, NPM, ROCE), liquidity ratios (current ratio, acid test), how to calculate and interpret ratios, and who uses financial accounts.
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How efficiently a business converts revenue into profit. Measured as a percentage — showing how much profit is made relative to revenue or capital invested.
Revenue minus Cost of Sales (Cost of Goods Sold). The profit before deducting overheads and other expenses.
Gross Profit minus all other operating expenses (overheads, wages, rent, interest etc.). Also called ‘Profit for the Year’.
The total long-term funds invested in a business. Calculated as: Total Assets − Current Liabilities (or Equity + Long-term Liabilities).
Why Profitability Matters
A declining profit margin warns of rising costs or falling prices — a signal to take action before problems worsen.
Investors and shareholders use it to assess whether the business is worth investing in or holding shares in.
Managers use it to identify areas of cost inefficiency or pricing weakness within the business.
Banks assess profitability when deciding whether to lend money — signals ability to repay loans.
Allows comparison against competitors and industry benchmarks to assess relative performance.
A business can be making profit in absolute terms but still have poor profitability if its margins are low or declining over time. Always measure profitability as a percentage — not just as a £ figure.
A business’s ability to meet its short-term financial obligations (debts due within 12 months) using its current assets. A business can be profitable but still fail due to poor liquidity.
🎯 Activity 1 — Sort Into the Right Category
Drag each item into the correct column. All 8 items must be placed to check your answer.
📊 Activity 2 — Liquidity Gauge
Move the slider to see how a current ratio changes zone — and what it means for the business.
🩺 Activity 3 — Diagnose the Business
Read the ratio data and click the correct diagnosis.
📋 Activity 4 — Liquid or Not?
Click each scenario card to reveal whether the business has a liquidity problem and why.
Classic example of profitable but illiquid. Profit is recorded in accounts, but cash may be tied up in stock, receivables or long-term assets. The chain must manage working capital — not just profit.
The business is liquid right now — it can pay its bills. But without profitability, the cash will run out. Investors will be concerned about the long-term viability even though short-term obligations are met.
This is overtrading — expanding faster than cash flow can support. Stock, staff and store costs are paid before sales revenue arrives. Even with rising sales, the business can fail from a cash flow crisis.
The ratio is too high. Excess cash earns little return — it should be invested in equipment, R&D or expansion. Shareholders may question why profits aren’t being reinvested or distributed as dividends.
Profitability ≠ Liquidity. A profitable business CAN fail if it runs out of cash. Always treat these as separate concepts — and always explain the reason behind a poor ratio, not just that it’s low.
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Revenue
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Revenue
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Capital Employed
(beat the interest rate)
🧮 Interactive Ratio Calculator
Enter values below and click Calculate to see the ratio and its meaning.
Gross Profit Margin (GPM)
Revenue: $500,000
Gross Profit: $200,000
GPM = 200,000 ÷ 500,000 × 100 = 40%
💬 40p of every $1 of revenue is gross profit.
- Controlling production costs well
- Strong pricing power over customers
- Efficient purchasing of raw materials
- Selling premium / high-value products
- Cost of sales (materials, labour) rising
- Business cutting prices to compete
- Buying from more expensive suppliers
- Inefficient production methods
Net Profit Margin (NPM)
Revenue: $500,000
Net Profit: $75,000
NPM = 75,000 ÷ 500,000 × 100 = 15%
💬 15p of every $1 of revenue is net profit.
- Overheads (rent, admin, wages) well controlled
- Strong revenue relative to total costs
- Good management of interest payments on debt
- High overhead costs (rent, salaries, admin)
- High interest payments on loans
- Revenue falling but fixed costs remain
- GPM high but NPM low = overhead problem
Return on Capital Employed (ROCE)
Net Profit: $75,000
Capital Employed: $375,000
ROCE = 75,000 ÷ 375,000 × 100 = 20%
💬 $20 profit for every $100 invested.
- Business generating strong returns on investment
- Capital is being used productively
- Attractive to investors — beats bank interest
- Should ideally exceed the interest rate on borrowing
- Net profit falling
- Capital employed rising without matching profit growth
- Assets being underutilised
- Heavy borrowing increasing capital base
If a business has a HIGH GPM but LOW NPM:
- Production/purchasing is efficient — good markup over direct costs ✅
- BUT overheads (rent, salaries, admin, interest) are very high — eating into gross profit ❌
- Solution: investigate and reduce overhead costs, not production costs
If BOTH GPM and NPM are low → the problem is with the cost of sales (materials, labour, manufacturing).
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Current Liabilities
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Current Liabilities
🧮 Liquidity Calculator
Enter values to calculate both ratios at once.
Current Ratio
Current Assets: $90,000
Current Liabilities: $50,000
= 90,000 ÷ 50,000 = 1.8 : 1
💬 Healthy — can comfortably cover short-term debts.
- Can cover short-term debts comfortably
- Enough working capital to operate smoothly
- Suppliers and banks will view the business positively
- Low risk of insolvency from short-term debts
- < 1: Cannot pay short-term debts — insolvency risk
- < 1.5: Tight — limited safety margin
- > 2: Too much cash/stock sitting idle — inefficient use of assets
- Very high: may indicate slow stock turnover
Acid Test Ratio (Quick Ratio)
Current Assets: $90,000
Stock: $30,000
Current Liabilities: $50,000
= (90,000 − 30,000) ÷ 50,000 = 1.2 : 1
💬 Healthy — can pay debts without selling stock.
- Can cover all short-term debts with liquid assets
- Not reliant on selling stock to meet obligations
- Strong cash and receivables position
- < 1: Cannot pay debts without selling stock — risky for slow-moving stock businesses
- Very low: possible cash flow crisis ahead
- Current ratio OK but acid test poor = too much cash tied up in stock
- Includes ALL current assets (cash + debtors + stock)
- Ideal range: 1.5 : 1 to 2 : 1
- Less strict — assumes stock can eventually be sold
- Better for businesses with fast-moving stock (e.g. supermarkets)
- Excludes stock — only uses liquid assets (cash + debtors)
- Ideal: ≥ 1 : 1
- Stricter — stock may be difficult to sell quickly
- Better for businesses with slow-moving stock (e.g. car dealers)
If the current ratio is fine but acid test is low → too much money is tied up in stock. If both are low → the business has a genuine cash flow problem. Always compare both ratios together.
Who Uses Accounts and Why?
Click each stakeholder to see which ratios they use and why.
Assess whether the business is generating sufficient returns on investment. Decide whether to buy, hold or sell shares. Compare against alternative investments. Will ROCE beat the bank interest rate?
Decide whether to lend money or extend credit. Assess whether the business can repay loans and interest. Monitor an existing borrower’s financial health over time.
Identify areas of weak performance. Set targets for improvement. Compare with previous years (trend analysis) and with competitors. Make strategic decisions about costs, pricing and investment.
Assess whether to offer trade credit (buy now, pay later). Check if the business is likely to pay its invoices on time. Decide credit limits and payment terms.
Calculate how much corporation tax the business owes. Monitor compliance with tax law. Identify businesses that may be avoiding tax through manipulation of accounts.
Assess whether the business can afford pay rises or improved conditions. Evaluate job security. Negotiate wage claims based on business profitability and performance.
Benchmark their own performance against rivals. Identify a competitor’s strengths and weaknesses. Decide whether to target their customers or replicate their strategies.
Limitations of Ratio Analysis
For evaluate questions: always consider the limitations of the ratio — does it give the full picture? State the ratio value, judge if it’s good/bad in context, then explain why using specific details from the question.
| Ratio | Formula | Ideal | What It Shows |
|---|---|---|---|
| Gross Profit Margin | Gross Profit ÷ Revenue × 100 | Higher = better | % revenue left after cost of sales only |
| Net Profit Margin | Net Profit ÷ Revenue × 100 | Higher = better | % revenue left after ALL costs deducted |
| ROCE | Net Profit ÷ Capital Employed × 100 | Higher = better (beat interest rate) | Return generated per $100 of capital invested |
| Current Ratio | Current Assets ÷ Current Liabilities | 1.5 : 1 to 2 : 1 | Ability to pay short-term debts (includes stock) |
| Acid Test Ratio | (Current Assets − Stock) ÷ Current Liabilities | ≥ 1 : 1 | Stricter liquidity test — excludes stock |
GPM high + NPM low = overhead problem. Both low = cost of sales problem.
Always compare ROCE to bank interest rate. If ROCE < interest rate → not worth investing.
Current ratio OK + acid test low = too much cash tied up in stock.
A profitable business CAN fail from poor liquidity (overtrading, cash flow crisis).
Liquidity ratios (can the business repay loans and interest on time?).
Profitability ratios — especially ROCE (is the return better than alternatives?).
Businesses may manipulate accounts at year end to make ratios look better than they are.
Historical data, no universal ideal, don’t explain WHY, ignore qualitative factors.
FastFit is a UK gym chain. Its latest accounts show: Revenue $2,000,000 · Gross Profit $1,400,000 · Net Profit $200,000 · Capital Employed $1,000,000.
- Calculation: ROCE = 200,000 ÷ 1,000,000 × 100 = 20% (1 mark)
- Interpretation: $20 net profit generated per $100 of capital invested (1 mark)
- Analysis: Investor views this favourably if 20% exceeds the bank interest rate — FastFit is a worthwhile investment compared to alternatives (1 mark)
AutoElite is a luxury car dealership. Current Assets: $500,000 · Inventory (cars): $420,000 · Current Liabilities: $300,000. Its current ratio is 1.67 : 1.
- Calculation: Acid Test = (500,000 − 420,000) ÷ 300,000 = 0.27 : 1 (1 mark)
- Application: Almost all current assets are slow-moving car inventory (1 mark)
- Analysis: Cannot pay short-term debts without selling cars, which takes time — genuine liquidity risk despite healthy current ratio (1 mark)
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