IGC-L26 — Accounting Ratios
Analysing financial performance and position using key accounting ratios.
Learning Objectives
- define accounting ratios
- calculate profitability, liquidity and efficiency ratios
- interpret ratio results
- compare business performance
- understand limitations of ratio analysis
Concept Framework
What are Accounting Ratios?
Accounting ratios are relationships between financial figures used to evaluate business performance.
They help users analyse:
• profitability
• liquidity
• efficiency
Types of Ratios
1. Profitability Ratios
Measure how effectively a business generates profit.
Gross Profit Margin
Net Profit Margin
2. Liquidity Ratios
Measure the ability to meet short-term obligations.
Current Ratio
Acid Test Ratio
3. Efficiency Ratios
Measure how effectively resources are used.
Inventory Turnover
Trade Receivables Collection Period
Ratio Summary Table
Profitability:
Gross Profit Margin
Net Profit Margin
Liquidity:
Current Ratio
Acid Test Ratio
Efficiency:
Inventory Turnover
Receivables Collection Period
📊 ONE-PAGE RATIO MEMORY CHART
🧠 “PNL → CA/CL → Efficiency”
Gross Profit ÷ Revenue × 100
Net Profit ÷ Revenue × 100
————————————–
STEP 2 → Liquidity (Current Position)
Current Assets ÷ Current Liabilities
(Current Assets − Inventory) ÷ Current Liabilities
————————————–
STEP 3 → Efficiency (Usage of Resources)
Cost of Sales ÷ Average Inventory
Trade Receivables ÷ Revenue × 365
📌 QUICK MEMORY FORMULAS
Profitability
Net Profit Margin = NP ÷ Revenue × 100
Liquidity
Acid Test = (CA − Inventory) ÷ CL
Efficiency
Receivables Days = Receivables ÷ Revenue × 365
⚡ ULTRA-SHORT MEMORY TRICK
Liquidity → CA/CL
Efficiency → Speed
📊 INTERPRETATION QUICK GUIDE
LOW NP% → High expenses
HIGH Current Ratio → Safe liquidity
LOW Current Ratio → Risk of cash shortage
HIGH Inventory Turnover → Fast sales
LOW Turnover → Slow-moving stock
HIGH Receivable Days → Slow collection
LOW Receivable Days → Good credit control
⚠ COMMON EXAM MISTAKES
• Using profit instead of revenue
• Not subtracting inventory in acid test
• Mixing receivables with payables
📊 GOOD vs BAD RATIO BENCHMARK TABLE
🧠 Use this for Interpretation Questions
🔹 Profitability Ratios
High → Good pricing / low cost of sales
Low → Poor pricing or high cost of sales
—————————————
Net Profit Margin (NP%)
High → Good cost control
Low → High expenses / poor control
🔹 Liquidity Ratios
Ideal → Around 2 : 1
Too High → Idle resources / inefficient use
Too Low → Risk of liquidity problems
—————————————
Acid Test Ratio
Ideal → Around 1 : 1
Too High → Excess liquid assets
Too Low → Difficulty paying short-term debts
🔹 Efficiency Ratios
High → Fast sales / efficient stock management
Low → Slow-moving or obsolete inventory
—————————————
Receivables Collection Period
Low (fewer days) → Quick cash collection
High (more days) → Poor credit control
⚡ QUICK EXAM INTERPRETATION RULE
Liquidity → Balanced is best (not too high, not too low)
Efficiency → Faster is better
🧠 SUPER MEMORY LINE
Liquidity → Balanced
Efficiency → Fast
⚠ EXAM TIP (VERY IMPORTANT)
Never just say:
❌ “This is good”
❌ “This is bad”
Always say:
✔ what it means
✔ why it happened
✔ its effect on the business
Example:
A low net profit margin indicates high operating expenses, which reduces overall profitability.
Interpretation of Ratios
Ratios must be interpreted, not just calculated.
Examples:
• High profit margin → good cost control
• Low current ratio → liquidity risk
• Slow receivables → poor credit control
Worked Examples
Revenue = £100,000
Gross Profit = £40,000
Net Profit = £20,000
Gross Profit Margin
Net Profit Margin
Current Assets = £50,000
Current Liabilities = £25,000
Current Ratio
📌 Additional ratio-based questions are available in the
🎯 Lesson wise resources, Module wise resources , Guess Question Papers + YouTube Explanation section.
Students should practise ratio calculations regularly.
Structured Practice
Level 1 – Concept Check
Define accounting ratio.
State one profitability ratio.
State one liquidity ratio.
Level 2 – Application Practice
Revenue = £80,000
Net Profit = £16,000
Calculate net profit margin.
Level 3 – Examination Style Question
1. Explain why ratio analysis is useful to a business owner. (4 marks) …… 📌 Additional structured questions are available in the 🎯 Lesson wise resources, Module wise resources, Guess Question Papers + YouTube Explanation section.</p>
Enrolled students may submit questions from recognised textbooks, past examination papers or other genuine academic material for expert clarification through the Student Doubt Support facility.
Proficiency Check
Learn → Unlearn → Relearn
Students who believe they understand this topic should attempt:
- Explain why ratios must be interpreted and not just calculated.
Revenue = £120,000
Gross Profit = £60,000Calculate gross profit margin.
- Explain one limitation of ratio analysis.
If unsure, review the lesson.
Detailed Activity Solutions
Solution to Level 2 question
16,000 ÷ 80,000 × 100 = 20%
Solutions to Proficiency Check
60,000 ÷ 120,000 × 100 = 50%
How This Topic Appears in the Examination
This topic commonly appears through:
• ratio calculations
• interpretation questions
• comparison questions
Examiners frequently assess:
• correct formulas
• accurate calculations
• meaningful interpretation
Students should practise ratio questions regularly and review video explanations for clarity.
Enrolled students may submit questions from recognised textbooks, past examination papers or other genuine academic material for expert clarification through the Student Doubt Support facility.
Self-Assessment Checklist
- I can calculate key ratios
- I understand ratio formulas
- I can interpret results
- I understand limitations
Continue Your Preparation
Go beyond the lesson with curated resources, examination practice and video learning.
PREMIUM RESOURCES
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GUESS PAPERS
Prepare for the examination with complete Guess Paper packages and Mark Schemes.
VIDEO ON DEMAND
Watch, revise and strengthen your understanding with Shasha Academy videos.