6.1 Calculation and Understanding of Accounting Ratios

2026 Syllabus Objectives

By the end of this topic, you should be able to calculate and understand:

  1. Gross margin
  2. Profit margin
  3. Return on capital employed (ROCE)
  4. Current ratio
  5. Liquid (acid test) ratio
  6. Rate of inventory turnover (times)
  7. Trade receivables turnover (days)
  8. Trade payables turnover (days)

What Is Ratio Analysis?

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Ratio analysis is a way of looking at a business's financial records to judge how well it is performing. Instead of just reading through numbers in financial statements, ratios turn those numbers into simple comparisons that are easy to understand.

Ratios are useful because they allow you to:

  • Compare a business's performance this year with how it performed last year
  • Compare one business against another similar business
  • Spot problems early and make better decisions

There are three main groups of ratios:

  • Profitability ratios — measure how much profit the business is making
  • Liquidity ratios — measure whether the business can pay its short-term debts
  • Efficiency ratios — measure how well the business manages its day-to-day activities

Part 1: Profitability Ratios

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Profitability ratios tell you how good a business is at turning its sales into profit. The three profitability ratios you need to know are: gross margin, profit margin, and return on capital employed (ROCE).

1. Gross Margin

What it measures: The gross margin tells you what percentage of a business's revenue (total sales money) becomes gross profit after paying for the cost of the goods sold.

Gross profit is the money left over from sales after subtracting the cost of buying or making the goods. It does not yet take into account expenses like rent, wages, or electricity.

Formula:

Gross Margin = (Gross Profit ÷ Revenue) × 100

Answer format: Write as a percentage (e.g. 45%)

Important note: The gross margin must always be less than 100%. If your answer is over 100%, you have made an error — check your working.

What a high gross margin means: The business is keeping a large share of its sales income as gross profit. It is either selling goods at a high price or buying them cheaply.

What a low or falling gross margin might mean:

  • The business has reduced its selling prices (perhaps to attract more customers)
  • The business is giving more trade discounts to customers
  • The cost of buying goods has gone up but selling prices stayed the same

How to improve the gross margin:

  • Increase the selling price of goods
  • Find a cheaper supplier so that cost of sales falls

Worked Example:

A business has revenue of USD 200,000 and cost of sales of USD 120,000.

  • Gross Profit = USD 200,000 − USD 120,000 = USD 80,000
  • Gross Margin = (80,000 ÷ 200,000) × 100 = 40%

This means for every USD 1 of sales, the business keeps USD 0.40 as gross profit before paying any expenses.

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