The two statements you must be able to read

An income statement covers a period (a year): revenue, then the costs, arriving at gross profit, operating profit and profit for the year.

A balance sheet (statement of financial position) is a snapshot on one day: what the business owns and owes.

Check it: capital employed = £3,600,000 + £2,400,000 = £6,000,000. The other route gives the same: £5,000,000 + (£2,000,000 − £1,000,000) = £6,000,000. ✓

The ratios AQA requires

• Profitability — ROCE. The single most important ratio: how much operating profit every £100 of long-term capital generates. It answers "is this business worth the money tied up in it?"
• Liquidity — the current ratio. Can the firm pay its short-term bills?
• Gearing — how much of the long-term funding is debt. A measure of financial risk.
• Efficiency — receivables days, payables days, inventory turnover. How well is working capital being managed?

Which family of ratios?

Tap a ratio, then tap the family it belongs to.

Your turn — ROCE

Interpreting ROCE

Northgate earns 16p of operating profit for every £1 of long-term capital invested in it. That figure is meaningless alone. Compare it with:

• Last year — is it rising or falling, and why?
• Competitors — 16% is excellent in grocery retail and mediocre in software.
• The cost of borrowing. This is the decisive comparison. If the firm can borrow at 6% and earn 16%, borrowing to invest creates value. If ROCE fell to 5%, the business would be destroying value with every pound it borrowed — it would be better off closing and putting the money in the bank.

Two routes to a higher ROCE: raise operating profit (better margins, higher volume, lower overheads), or reduce capital employed (sell underused assets, cut inventories, lease rather than buy). The second route is why a firm can raise ROCE without selling a single extra unit — and why a rising ROCE always deserves the question "which route?"

Your turn — current ratio

Is a higher current ratio better?

Your turn — gearing

Interpreting gearing

Gearing of 40% means 40% of Northgate's long-term funding is debt. As a rough guide: above 50% is highly geared; below 25% is low geared.

High gearing is not simply "bad" — it is a leverage bet.

• Advantages: debt is cheaper than equity, interest is tax-deductible, and it does not dilute ownership or control. If ROCE (16%) comfortably exceeds the interest rate (say 6%), every extra pound borrowed magnifies the return to shareholders.
• Dangers: interest must be paid whatever happens — in a recession, in a bad year, in a pandemic. High gearing turns a downturn in profits into a solvency crisis. It makes the firm acutely vulnerable to rising interest rates, restricts its ability to borrow again, and often comes with covenants that constrain what management can do.

The judgement always depends on two things: how stable and predictable the firm's cash flows are (a water utility can carry gearing that would destroy a fashion retailer), and where interest rates are heading. 40% gearing with rock-solid contracted revenue is prudent; 40% in a cyclical business facing a rate rise is a live risk.

Gearing, rates and risk

Your turn — receivables days

Your turn — payables days

Your turn — inventory turnover

Putting the efficiency ratios together

What each ratio is telling you:

• Receivables days rising → credit control is slipping, or customers are in trouble. Cash is walking out of the door.
• Payables days rising → the firm is stretching its suppliers. It may be smart cash management; it may be a symptom that it cannot pay. And suppliers eventually retaliate with higher prices or a lower priority.
• Inventory turnover falling → stock is moving more slowly: obsolescence, over-ordering or falling demand. Rising → efficient, but push it too far and you get stock-outs.

Compare like with like. A supermarket turns its inventory over 25+ times a year; a jeweller perhaps 2. Neither figure is "good" or "bad" until you know the sector. And be sure to use cost of sales (not revenue) for payables days and inventory turnover — using revenue is the most common calculation error in this topic.

A deteriorating ratio

Match each ratio to its formula

Tap an item on the left, then its partner on the right.

The value — and the limits — of ratio analysis

Value: ratios convert raw, incomparable numbers into a common language. They let a firm be compared over time and against rivals of a completely different size, and they point management at where the problem lies — profitability, liquidity, gearing or efficiency.

Limits:

• They are historic — published accounts describe a year that has already ended.
• They are based on one day's balance sheet, which can be flattered (a firm can delay paying suppliers just before the year end to look liquid — "window dressing").
• They ignore everything qualitative: the quality of the management, the strength of the brand, staff morale, the state of the R&D pipeline. None of these appear anywhere in the accounts, and all of them determine the future.
• They ignore the external environment — a firm whose ratios all worsened during a recession may have outperformed its whole sector.
• Different firms use different accounting policies, so cross-company comparison is never quite like-for-like.

Beyond the accounts: measuring overall performance

The spec requires you to analyse non-financial data too: operations data (capacity utilisation, defect rates, lead times), HR data (labour turnover, productivity, engagement), and marketing data (market share, brand loyalty, customer satisfaction). These are leading indicators — they tell you what the financial statements will say in two years' time.

Core competences (Hamel and Prahalad) are the capabilities that give a firm its advantage. A true core competence must be: valuable to customers, rare, difficult to imitate, and applicable across several markets. A brand, a patented process, an engineering culture. The strategic warning: outsourcing a core competence destroys the very thing the firm competes on — and you cannot buy it back.

• Kaplan and Norton's Balanced Scorecard measures performance across four perspectives: financial · customer · internal business processes · learning and growth. Its whole purpose is to stop managers optimising the financial number at the expense of the other three — which is precisely how short-termism happens. Its cost: it is complex, data-hungry, and if the four sets of measures conflict it does not tell you which wins.
• Elkington's Triple Bottom Line judges the firm on Profit, People and Planet. It forces social and environmental impact onto the same page as profit. Its weakness is measurement: profit is precise, "People" and "Planet" are not — which makes the framework vulnerable to greenwashing.

Short- vs long-term performance: a firm can look magnificent this year (profit up, ROCE up) by starving the very things that will produce next decade's profit. That is why the Balanced Scorecard exists — and why you should never assess a business on the income statement alone.

Where did the ROCE come from?

Thinking like an examiner

• Never quote a ratio without a comparison. Over time, against rivals, against the sector norm, against the cost of borrowing. A number on its own earns AO1 and nothing more.
• Always ask which component moved. A ratio can improve because the numerator rose or because the denominator fell — and those are two completely different stories.
• Read the ratios as a system. Rising receivables days → falling current ratio → overdraft → interest → falling ROCE. The chain is the analysis.
• The accounts cannot see the future. Brand, morale, R&D, management quality and customer satisfaction are absent from every ratio and decide everything. That is the case for the Balanced Scorecard.

The big ideas to know

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