ACCT10001 · Accounting Reports And Analysis
Ratio Analysis
Topic 6 turns the statements into judgement: five families of ratios (profitability, efficiency, liquidity, gearing and market), the ROA decomposition into asset turnover and profit margin, and the operating and cash cycles that measure how long cash is tied up in working capital. It is examined in the exam's Case 2 (Common-sized financial statements, 5 marks, with Topic 1) and again in the integrated Case 4 (33 marks). The course's caution is that ratios inform judgement — they do not answer questions — so every number must be paired with a one-line interpretation, which is where the marks sit.
What this chapter covers
- 011. Why ratios inform but do not answer: compare like-with-like, focus on trends, context matters; benchmarks (prior years, peers, heuristics, forecasts)
- 022. Profitability: ROE, ROA, gross profit margin, EBIT (profit) margin
- 033. ROA decomposition: ROA = Asset turnover × Profit margin = (Sales/Assets) × (EBIT/Sales) = EBIT/Assets
- 044. Efficiency: asset turnover, inventory days, receivables days, payables days
- 055. Liquidity: current ratio and quick ratio (quick strips out inventory)
- 066. Gearing/capital structure: debt ratio, debt-to-equity, times interest earned
- 077. Market: earnings per share, P/E ratio, net tangible asset backing
- 088. Operating cycle = inventory days + receivables days; cash cycle = inventory days + receivables days − payables days (can be negative)
Compute and interpret profitability and liquidity ratios
- 1 mark(a) Gross profit margin = gross profit ÷ revenue = 2,000 ÷ 5,000 = 40%.
- 2 marks(b) ROA = profit after tax ÷ average total assets = 380 ÷ 2,500 = 15.2%. (c) ROE = profit after tax ÷ average equity = 380 ÷ 1,500 = 25.3%.
- 1 mark(d) Current ratio = current assets ÷ current liabilities = 900 ÷ 600 = 1.5. (e) Quick ratio = (current assets − inventory) ÷ current liabilities = (900 − 500) ÷ 600 = 0.67.
- 1 markThe quick ratio better reflects immediate obligations because it excludes inventory — the least-liquid current asset, which may not convert to cash quickly.
Key terms
- Return on assets (ROA) and its decomposition
- ROA measures how much profit the asset base generates. It decomposes as ROA = Asset turnover × Profit margin = (Sales/Assets) × (EBIT/Sales) = EBIT/Assets, separating how hard the assets are worked from how profitable each sale is. Use average assets and EBIT to isolate operations from financing and tax.
- Asset turnover
- Revenue ÷ average total assets — an efficiency ratio showing how many dollars of sales each dollar of assets generates. A price-differentiation strategy tends to give high turnover and low margin; product differentiation tends to give low turnover and high margin.
- Current ratio vs quick ratio
- Current ratio = current assets ÷ current liabilities. Quick ratio = (current assets − inventory) ÷ current liabilities. The quick ratio strips out inventory (the least-liquid current asset), so it better reflects the ability to meet immediate obligations.
- Debt-to-equity ratio
- Total liabilities ÷ total equity (sometimes borrowings ÷ equity) — a gearing ratio often set as a covenant threshold. Debt funding raises the numerator (pushing the ratio up); equity funding raises the denominator (pulling it down).
- Operating cycle
- Inventory days + receivables days — the number of days to convert inventory into cash. A shorter operating cycle means less working capital is needed.
- Cash cycle
- Inventory days + receivables days − payables days — the number of days cash is actually deployed. It can be negative when a firm collects from customers before it pays suppliers, in which case suppliers effectively fund operations.
Ratio Analysis FAQ
How is Topic 6 examined in ACCT10001?
Ratio analysis is examined in the exam's Case 2 (Common-sized financial statements, 5 marks, alongside business models in Topic 1) and again in the integrated Case 4 (33 marks), where liquidity, profitability and gearing ratios support the analysis. Computing the ratio earns some marks, but the interpretation earns more.
What is the ROA decomposition and why is it useful?
Return on assets splits into asset turnover times profit margin: ROA = (Sales/Assets) × (EBIT/Sales) = EBIT/Assets. It is useful because it shows whether a firm earns its return by working its assets hard (high turnover, low margin — a price-differentiation play) or by earning a fat margin on each sale (low turnover, high margin — product differentiation), which links strategy to the numbers.
What is the difference between the operating cycle and the cash cycle?
The operating cycle = inventory days + receivables days — the time to turn inventory into cash. The cash cycle subtracts payables days (inventory + receivables − payables) to show how long the firm's own cash is tied up. The cash cycle can be negative when the firm is paid by customers before it pays suppliers, which means suppliers are effectively financing operations. Slower inventory turnover lengthens both cycles and raises working-capital needs.
Why do I have to interpret ratios, not just calculate them?
Because the course's central caution is that financial statement analysis informs judgement — it does not answer questions. A ratio only means something against a benchmark (prior years, peers, a forecast) and in context. The exam awards most of the marks for the one-line interpretation that says what the number implies, so always pair the figure with its meaning.
Exam move
Build a single ratio map you can reproduce: the five families (profitability, efficiency, liquidity, gearing, market) with the headline ratios under each, plus the ROA decomposition inset (asset turnover × profit margin). Drill computing each ratio and, crucially, writing the one-line interpretation, because the exam rewards meaning over arithmetic. Memorise the working-capital timeline — operating cycle = inventory + receivables days, cash cycle subtracts payables days, and the cash cycle can go negative — since it is a recurring Case 2/Case 4 idea. Keep the course's caveats front of mind (compare like-with-like, watch trends, context matters, use average balances) so your interpretations are nuanced rather than mechanical.
