Financial Analysis and Decision Making
This domain tests how ratios turn financial statements into information for decisions. Expect questions on profitability, liquidity and efficiency ratios, and on interpreting changes rather than simply calculating figures.
Why ratios
Ratios relate figures to make comparison meaningful across years, against budgets or against competitors.
Key ratios
- Gross profit ratio = gross profit ÷ sales × 100. Shows trading efficiency before expenses.
- Net profit ratio = net profit ÷ sales × 100. Shows overall profitability.
- Return on capital employed = operating profit ÷ capital employed × 100.
- Current ratio = current assets ÷ current liabilities. A rough guide is 2:1; too low signals liquidity risk.
- Quick ratio = (current assets − stock) ÷ current liabilities. A rough guide is 1:1.
- Stock turnover = cost of sales ÷ average stock; shows how quickly stock is sold.
A rise in gross profit ratio with a fall in net profit ratio suggests expenses have risen. A high current ratio may mean idle stock or poor receivables collection, not necessarily strength. Compare like with like and consider non-financial factors.
Worked example
Sales Rs. 800,000; gross profit Rs. 320,000; net profit Rs. 170,000; current assets Rs. 300,000 including stock Rs. 100,000; current liabilities Rs. 150,000. GP ratio = 40%; NP ratio = 21.25%; current ratio = 2:1; quick ratio = (300,000 − 100,000) ÷ 150,000 = 1.33:1. Liquidity looks adequate, though stock is half of current assets.
Traps
Dividing by the wrong base; using net profit for the gross profit ratio; treating a high current ratio as always good; comparing firms in different industries without comment.