6.2 Interpretation of Accounting Ratios

2026 📋 Syllabus Objectives

By the end of these notes, you should be able to:

  1. Prepare and comment on simple statements that compare a business's results across different years.
  2. Make recommendations and suggestions for improving profitability and working capital.
  3. Understand the significance of the difference between the gross margin and the profit margin as an indicator of a business's efficiency.
  4. Explain the relationship of gross profit and profit for the year to the valuation of inventory, the rate of inventory turnover, revenue, expenses, and equity.

📘 Main Content

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Objective 1 — Comparing Results Across Different Years

Why Do We Compare Results?

A single year's figures tell us very little on their own. For example, knowing that a business made a gross profit of USD 20,000 this year doesn't tell us if that's good or bad. But if we know the business made USD 15,000 last year, we can immediately see that it has improved.

Comparing results across different years (called trend analysis — looking at how figures change over time) helps us to:

  • Spot whether the business is improving or getting worse.
  • Understand whether changes in ratios are a one-off event or a long-term pattern.
  • Make better decisions about how to run the business in the future.

What Is a Comparison Statement?

A comparison statement is a simple table or summary that places two or more years' figures side by side so that differences are easy to see at a glance. It typically shows both the raw figures (the actual numbers) and the calculated ratios for each year.

How to Prepare a Comparison Statement

Here is an example. Suppose a business called Star Traders has the following information:

ItemYear 1Year 2
Revenue (total sales)USD 100,000USD 120,000
Cost of Sales (what the goods cost)USD 60,000USD 78,000
Gross ProfitUSD 40,000USD 42,000
Expenses (e.g. rent, wages)USD 15,000USD 22,000
Profit for the Year (net profit)USD 25,000USD 20,000
Gross Margin40%35%
Profit Margin25%16.7%

Gross Margin = (Gross Profit ÷ Revenue) × 100 Profit Margin = (Profit for the Year ÷ Revenue) × 100

How to Comment on the Comparison

Once you have the statement, you must comment on what the figures show. A good comment has three parts:

  1. State what happened — Did the figure go up or down?
  2. Give the numbers — Mention the actual figures or percentages.
  3. Suggest a reason — Why might this have happened?

Example comment on the table above:

"The gross margin fell from 40% in Year 1 to 35% in Year 2. This means that for every USD 100 of sales, the business kept USD 5 less as gross profit. This could be because the cost of buying goods increased, or because the business reduced its selling prices to attract more customers."

"The profit for the year actually fell from USD 25,000 to USD 20,000, even though revenue went up. This suggests that expenses increased significantly — from USD 15,000 to USD 22,000 — which wiped out the increase in gross profit."

💡 Key point: Always compare both the direction of change (up or down) and the size of the change. A small percentage change can still have a big impact on the business.

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