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IGCSEBusinessEdexcelRevision Notes3. Business FinanceAnalysis of AccountsAccounting Ratios

Accounting Ratios (Edexcel IGCSE Business)

Revision Note

Lisa Eades

Written by: Lisa Eades

Reviewed by: Steve Vorster

An Introduction to Ratio Analysis

  • Ratio analysis involves extracting information from financial accounts to assess business performance 

  • It helps managers to answer key questions including 

    • Why is one business more profitable than another one in the same industry?

    • Is a business growing?

    • How effectively is a business using assets and capital invested?

    • What return on investment is expected?

    • How risky is the financial structure of the business?

  • Ratios can be compared over time and between businesses or functions to determine how well financial objectives are being met

Examiner Tips and Tricks

Formulas to calculate profit margins, mark up, RoCE and liquidity are provided on page 2 of your exam paper.

Profit Margins

  • Profit margins measure of how effectively a business converts revenue into profit

  • Profit margins can be compared to previous years' to better understand business performance

    • Higher and increasing profit margins are preferable, as it means that more revenue is being converted to profit

The Gross Profit Margin

  • This calculation shows the proportion of revenue that is turned into gross profit

    • It is calculated using the following formula and is expressed as a percentage

       Gross space Profit space Margin space equals space fraction numerator Gross space Profit over denominator Revenue end fraction cross times space 100 space space space space space space

Worked Example

Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its gross profit was $105,731

Calculate Head to Toe Wellbeing Ltd’s Gross Profit Margin in 2022 [2 marks]

 

Step 1: Substitute the values into the formula

Gross space profit space equals space fraction numerator Gross space profit space over denominator Revenue end fraction space cross times space 100 space space space equals space fraction numerator $ 105 comma 731 over denominator space $ 124 comma 653 space end fraction equals space space 0.8482 space   [1 mark]

  

Step 2: Multiply the outcome by 100 to find the percentage

equals space 0.8482 space cross times space 100 equals space 84.82 percent sign        [1 mark]

84.82% of Head to Toe Wellbeing’s revenue was converted into gross profit during 2022

Improving the Gross Profit Margin

  • The gross profit margin can be improved in two ways

    • The business can increase its sales revenue

    • The business can reduce its direct costs
       

Ways to Increase the Gross Profit Margin

Method

Explanation

Increase revenue

  • Increase the value of sales

  • Raise prices

    • If costs remain the same, this will improve profitability as the difference between the selling price and costs is now greater

  • Sell premium products

    • If customers are willing to spend money on these goods, the business could earn more profit per item sold
       

  • Increase the volume of sales

  • Price tactics 

    • Use price tactics to encourage higher quantity or more frequent purchases

  • Increase marketing activities

    • Engage in more marketing activities to increase sales volume

Reduce direct costs

  • Purchase cheaper/alternative resources

    • Negotiate with suppliers or find new suppliers

      • However businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products

  • Buy stock in greater quantities

    • Purchase in bulk amounts less frequently

      • Investment in increased storage space may be needed, which will reduce the impact of cost savings made

  • Reduce wastage of raw materials and components 

The Operating Profit Margin

  • This calculation shows the proportion of revenue that is turned into operating profit 

    • It is calculated using the formula below and the outcome is expressed as a percentage

text Operating Profit Margin =  end text fraction numerator Operating space Profit over denominator Revenue end fraction cross times 100

Worked Example

Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its operating profit was $65,864

Calculate Head to Toe Wellbeing Ltd’s Operating Profit Margin in 2022

[2 marks]

Step 1: Substitute the values into the formula

text Operating Profit Margin =  end text fraction numerator Operating space Profit over denominator Revenue end fraction cross times 100 equals space fraction numerator $ 65 comma 864 over denominator $ 124 comma 653 end fraction equals space 0.5284    [1 mark]

Step 2: Multiply the outcome by 100 to find the percentage

 

equals space 0.5284 space cross times space 100 equals space 52.84 percent sign                  [1 mark]

In 2022, 52.84% of Head to Toe Wellbeing’s revenue was converted into operating profit 

Improving the Operating Profit Margin

  • The profit margin can be improved in two ways

    • Increase the gross profit margin (see above)

    • Reduce expenses by cutting staffing levels, relocating to cheaper premises or changing utility companies

    • Reducing staffing levels may affect staff morale and negatively affect productivity

      • Relocation costs may outweigh some of the benefits of moving to a cheaper location

      • Replacing inefficient or outdated equipment may require staff training

Mark-up

  • The mark-up is a measure of profit made on each item sold

  • Some businesses calculate the markup in order to determine the price at which they should sell their products

    • This methods ensures that all costs are covered and that a profit will be made on every item they sell

  • Mark-up is expressed as a percentage and calculated using the formula

Markup space equals space fraction numerator Profit space per space item over denominator Cost space per space item end fraction space straight x space 100

Worked Example

Evolve Boards' bestselling penny skateboard costs $12.13 to produce. Each board is sold for $20.

Calculate the percentage markup on each penny skateboard sold [2 marks]

Step 1: Calculate the profit per item

equals space space $ 20 space minus space $ 12.13 equals space $ 7.87       [1 mark]       

 

Step 2: Divide profit per item by cost per item

equals space $ 7.87 space divided by space $ 12.13 equals space 0.6488

 

Step 3: Multiply the outcome by 100

equals space 0.6488 space cross times space 100 equals space 64.88 percent sign         [1 mark] 

Return on Capital Employed

  • The Return on Capital Employed (RoCE) measures how how effectively a business uses the capital invested in the business to generate profit

    • It is calculated using the formula below and is expressed as a percentage
       

Return space on space Capital space Employed space equals space fraction numerator Operating space Profit over denominator Capital space Employed end fraction space space cross times space 100

  • RoCE can be compared over time and with competitors

    • It can also be compared with other potential capital investments, such as savings rates

  • The Capital Employed figure is usually provided for you

    • If required, it is calculated using the formula

Capital space Employed space equals space Non minus current space Liabilities space plus space Equity

Worked Example

The table shows an extract from the company accounts of Keals Cosmetics.

Non-current Liabilities

€1.5 million

Revenue

€7 million

Equity

€15.4 million

Operating Profit

€2.2 million

 

Calculate Keals Cosmetics' Return on Capital Employed.

[3 marks]

 
Step 1: Calculate the capital employed   

Capital space employed space equals space Non minus current space liabilities space plus space Equity Capital space employed space equals space € 1.5 space straight m space plus space € 15.4 space straight m Capital space employed space equals space € 16.9 space straight m   [1 mark]
  

 

Step 2: Divide Operating Profit by Capital Employed

equals fraction numerator space Operating space Profit over denominator Capital space Employed end fraction space equals space fraction numerator € 2.2 space straight m over denominator € 16.9 space straight m end fraction equals space 0.13    [1 mark] 

Step 3: Multiply the result by 100 and express the outcome as a percentage

      

begin mathsize 16px style equals space 0.13 space cross times space 100 equals space 13 percent sign end style   [1 mark]

The capital employed in Keals Cosmetics has generated a return of 13%         

Improving RoCE

  • When analysing the RoCE, the higher the rate the better, as it indicates that the business is profitable and using its capital efficiently

    • Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk growth is being achieved

  • To increase the RoCE, a business can

    • Increase the level of profit generated without introducing new capital into the business

    • Maintain the level of profit generated whilst reducing the amount of capital in the business
       

Using RoCE to make decisions

  • RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to determine the most profitable option given the level of capital employed

Worked Example

Faced with increasing costs, Kent & Medway Properties Ltd is looking to close one of its three high street real estate branches.

The table below shows some key data for each of the branches.

Branch

Capital Employed 

Operating Profit

Sevenoaks

£2.4m

£0.37m

Whitstable

£3.1m

£0.57m

Rochester

£2.9m

£0.51m

 

Calculate the Return on Capital Employed (RoCE) for each branch and recommend which branch, on profitability terms, should close  

[5 marks]

 

Step 1: Apply the formula to calculate the RoCE for each branch

      RoCE equals space fraction numerator Operating space Profit over denominator Capital space Employed end fraction space space cross times space 100 RoCE space Sevenoaks space equals space fraction numerator £ 0.37 straight m over denominator £ 2.4 straight m end fraction space space cross times space 100 space equals space 15.42 percent sign space space space left square bracket 1 space mark right square bracket space space space RoCE space Whitstable space equals space fraction numerator £ 0.57 straight m over denominator £ 3.1 straight m end fraction space space cross times space 100 space equals space 18.39 percent sign space space left square bracket 1 space mark right square bracket RoCE space Rochester space equals space fraction numerator £ 0.51 straight m over denominator £ 2.9 straight m end fraction space space cross times space 100 space equals space 17.59 percent sign space space left square bracket 1 space mark right square bracket

 

Step 2: Identify the least profitable branch for closure

Sevenoaks [1 mark] is the least profitable branch with a RoCE of 15.42% [1 mark] and should be the branch selected for closure 

Examiner Tips and Tricks

When calculating financial ratios, check that you are using the correct units.

In some cases financial data is presented as raw figures (e.g. $14,520), but in most cases, you will be working in thousands ($000) or millions ($m).

  • Ensure that you convert correctly; e.g. $0.39 million is equal to $390,000 and $34.9 (000) is equal to $34,900

  • Make sure the decimal place is in the correct place

  • Calculate to two decimal places unless stated otherwise

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    Author
    Reviewer
    Lisa Eades

    Author: Lisa Eades

    Expertise: Business Content Creator

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.

    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.