A set of financial statements is a table of numbers. Is a profit of ₦4.2 million good? It depends on the sales, the assets and the capital behind it, and on what it was last year and what competitors earn. Ratios turn raw figures into comparisons: one number divided by another, as a percentage or a number of times.
They let an owner, lender or investor judge performance without being misled by the size of the business.
This topic covers the ratios that measure how well a company earns (profitability) and how well it uses its resources (efficiency). The next topic covers liquidity, long-term stability and comparisons across years. Both build on the statements you have prepared in the earlier topics, including the company statement of profit or loss.
Ratio analysis is a new syllabus item, but margin and mark-up calculations appear in the Section A of several past diets.
In 30 seconds
Gross margin = gross profit ÷ sales. Net margin = profit after tax ÷ sales. Operating margin = operating profit ÷ sales. Return on capital employed (ROCE) = profit before interest and tax ÷ (total assets − current liabilities). Return on equity (ROE) = profit after tax ÷ equity. Asset turnover = sales ÷ total assets. Efficiency: Inventory days = average inventory ÷ cost of sales × 365, Receivable days = average receivables ÷ credit sales × 365, Payable days = average payables ÷ credit purchases × 365.
Operating cycle = inventory days + receivable days. Cash conversion cycle = operating cycle − payable days. A ratio means little alone. Compare it with last year and with similar businesses.
Why interpret financial statements
Financial statements are raw data. Interpretation turns them into judgements about a company’s financial health, so that investors, lenders and managers can decide. The reasons are to evaluate performance, to make informed decisions, and to identify trends that may show risks or opportunities. Ratios are grouped into four categories: profitability, liquidity (short-term solvency), long-term solvency or stability, and shareholders’ ratios.
Efficiency ratios are often shown with profitability, and this topic covers both.
Profitability ratios
Profitability ratios show how well a company turns revenue and capital into profit. They are used to see how well revenue is converted into profit, to assess operating efficiency, and to compare over time and with other firms.
| Ratio | Formula | What it tells you |
|---|---|---|
| Gross profit margin | Gross profit ÷ sales × 100 | Control of production cost relative to selling price |
| Operating profit margin | Operating profit ÷ sales × 100 | Sales left after operating costs |
| Net profit margin | Net profit (after tax) ÷ sales × 100 | Overall cost management including interest and tax |
| Return on capital employed (ROCE) | Profit before interest and tax ÷ capital employed × 100, where capital employed = total assets − current liabilities | How well all long-term funds earn profit |
| Return on equity (ROE) | Net profit (after tax) ÷ total equity × 100, where equity = assets − liabilities | Return to shareholders |
| Asset turnover | Sales ÷ total assets (times) | Sales generated per naira of assets |
Illustration (Eko Ltd). Sales ₦45,000,000, cost of sales ₦27,000,000, total expenses ₦12,000,000 including interest of ₦750,000, tax ₦1,800,000, total assets ₦15,000,000, current liabilities ₦2,500,000 and equity ₦10,000,000.
| Ratio | Working | Result |
|---|---|---|
| Gross profit margin | (45,000,000 − 27,000,000) ÷ 45,000,000 | 40% |
| Profit before tax | 45,000,000 − 27,000,000 − 12,000,000 | ₦6,000,000 |
| Net profit margin | (6,000,000 − 1,800,000) ÷ 45,000,000 | 9.33% |
| Operating profit (PBIT) | 6,000,000 + 750,000 | ₦6,750,000 |
| Operating profit margin | 6,750,000 ÷ 45,000,000 | 15% |
| ROCE | 6,750,000 ÷ (15,000,000 − 2,500,000) | 54% |
| ROE | 4,200,000 ÷ 10,000,000 | 42% |
| Asset turnover | 45,000,000 ÷ 15,000,000 | 3 times |
The company earns 40 kobo of gross profit on every ₦1 of sales, keeps 15 kobo as operating profit and 9.3 kobo as profit for the year, and earns 54% on the capital employed in the business. Always state the meaning in words, not just the number.
Efficiency ratios
Efficiency ratios show how quickly the business turns inventory, receivables and payables into revenue and cash. They are most useful when compared with past years or industry norms.
| Ratio | Formula |
|---|---|
| Inventory turnover | Cost of sales ÷ average inventory, where average = (opening + closing) ÷ 2 |
| Receivables turnover | Net credit sales ÷ average trade receivables |
| Payables turnover | Credit purchases ÷ average trade payables |
| Asset turnover | Net sales ÷ average total assets |
| Working capital turnover | Net sales ÷ average working capital (current assets − current liabilities) |
| Non-current asset turnover | Net sales ÷ average non-current assets |
| Inventory days | Average inventory ÷ cost of sales × 365, or 365 ÷ inventory turnover |
| Receivable days | Average receivables ÷ net credit sales × 365, or 365 ÷ receivables turnover |
| Payable days | Average payables ÷ credit purchases × 365, or 365 ÷ payables turnover |
| Operating cycle | Inventory days + receivable days |
| Cash conversion cycle | Operating cycle − payable days |
Illustration (Aba Ltd). Net sales ₦24,000,000, cost of sales ₦14,400,000 and credit purchases ₦10,800,000. Inventory was ₦1,200,000 and ₦1,600,000, receivables ₦1,800,000 and ₦2,200,000, payables ₦1,500,000 and ₦1,800,000, working capital ₦3,000,000 and ₦3,600,000, non-current assets ₦6,000,000 and ₦7,200,000, and total assets ₦10,800,000 and ₦12,000,000.
| Ratio | Working | Result |
|---|---|---|
| Inventory turnover | 14,400,000 ÷ 1,400,000 | 10.29 times |
| Receivables turnover | 24,000,000 ÷ 2,000,000 | 12 times |
| Payables turnover | 10,800,000 ÷ 1,650,000 | 6.55 times |
| Asset turnover | 24,000,000 ÷ 11,400,000 | 2.11 times |
| Working capital turnover | 24,000,000 ÷ 3,300,000 | 7.27 times |
| Non-current asset turnover | 24,000,000 ÷ 6,600,000 | 3.64 times |
| Inventory days | 1,400,000 ÷ 14,400,000 × 365 | 35.5 days |
| Receivable days | 365 ÷ 12 | 30.4 days |
| Operating cycle | 35.5 + 30.4 | 65.9 days |
| Payable days | 365 ÷ 6.55 | 55.8 days |
| Cash conversion cycle | 65.9 − 55.8 | 10.1 days |
The business holds inventory for about 36 days and waits about 30 days to collect, so it takes about 66 days to turn inventory into cash. It takes about 56 days to pay suppliers, so only about 10 days of its own money is tied up. A shorter cycle means cash is released sooner. A longer payable period helps cash but may harm supplier relations.
Margin and mark-up
A Margin is profit as a percentage of Selling price. A Mark-up is profit as a percentage of Cost. They are not the same, and the exam tests the difference.
| Source diet item | Working | Answer |
|---|---|---|
| Opening inventory ₦700,000, purchases ₦1,200,000, closing inventory ₦400,000, gross margin 40%. Sales? (November Diet 2014, Section A, Question 16) | Cost of sales = 700,000 + 1,200,000 − 400,000 = 1,500,000. Cost is 60% of sales, so 1,500,000 ÷ 0.60. | ₦2,500,000 |
| Sold at ₦250,000 at cost plus a mark-up of 20%. Profit? (May Diet 2019, Section A, Question 18) | Selling price is 120% of cost, so profit = 20 ÷ 120 × 250,000. | ₦41,667 |
| Cost of goods sold ₦3,000,000 (about), profit margin 5%. Gross profit? (May Diet 2021, Section A, Question 14) | Margin 5% means cost is 95% of sales, so profit = 5 ÷ 95 × cost of goods sold. | ₦157,900 |
A mark-up of 25% is a margin of 25 ÷ 125 = 20%. A margin of 20% is a mark-up of 20 ÷ 80 = 25%.
Interpreting the ratios
A single ratio is only a number. To interpret, compare it with the previous year and with similar businesses, and ask why it moved. A fall in gross margin points to higher costs, lower selling prices or a change in sales mix. A fall in net margin with a stable gross margin points to higher overheads or interest.
A high ROCE can come from a high margin, a high asset turnover or both, as the diagram shows. Rising inventory days may signal slow sales or overstocking, and rising receivable days may signal weaker credit control or a deliberate relaxing of terms to win sales. Lengthening payable days may be good for cash but warns of a possible liquidity problem.
The ideas in more depth
Points to watch. The Eko Ltd asset turnover working is written with capital employed in its formula line, but the numbers use total assets (45,000,000 ÷ 15,000,000), and the result of 3 times is for total assets. Use total assets. The profitability asset turnover there uses year-end figures, while the efficiency version uses averages, so state which you use.
The “operating profit” in the Eko example is found by adding the interest back to profit before tax, which is the usual way. Net profit in ROE is profit after tax.
Background. Return on assets (profit after tax ÷ total assets) is net margin × asset turnover. For Eko Ltd, 9.33% × 3 = 28%, which is 4,200,000 ÷ 15,000,000. ROCE is operating margin × capital turnover, as the figure shows: 15% × 3.6 = 54%. Ratios are only as good as the data. Different accounting policies, such as depreciation or inventory valuation, can change ratios.
Worked example: Jos Ceramics Ltd
Scenario. Jos Ceramics Ltd reports (₦): in year 1, sales 600,000, cost of sales 360,000, operating expenses 120,000, interest 12,000, total assets 500,000, current liabilities 100,000 and equity 300,000. In year 2, sales 720,000, cost of sales 468,000, operating expenses 132,000, interest 18,000, total assets 640,000, current liabilities 120,000 and equity 330,000. Tax is 30% of profit before tax. Required: gross margin, operating margin, net margin, ROCE, ROE and asset turnover for both years, with a comment.
| Ratio | Year 1 | Year 2 |
|---|---|---|
| Gross profit | 240,000 | 252,000 |
| Gross margin | 40.0% | 35.0% |
| Operating profit | 120,000 | 120,000 |
| Operating margin | 20.0% | 16.7% |
| Profit before tax | 108,000 | 102,000 |
| Profit after tax (70%) | 75,600 | 71,400 |
| Net margin | 12.6% | 9.9% |
| Capital employed | 400,000 | 520,000 |
| ROCE | 30.0% | 23.1% |
| ROE | 25.2% | 21.6% |
| Asset turnover | 1.20 times | 1.13 times |
Comment. Sales grew by 20%, but the gross margin fell from 40% to 35%, so cost of sales rose faster than sales, perhaps from price cuts or dearer materials. Operating profit did not grow at all, so the operating margin fell. Interest rose from ₦12,000 to ₦18,000, which points to more borrowing.
The business used more assets and capital but earned the same operating profit, so ROCE fell from 30% to 23.1%, ROE fell to 21.6% and asset turnover slipped. Growth in sales was bought at the cost of profitability.
Common mistakes in the exam
- Using profit after tax for ROCE. ROCE uses profit before interest and tax.
- Forgetting to deduct current liabilities from total assets to find capital employed.
- Confusing margin with mark-up, or using the wrong base.
- Using year-end figures when the question asks for averages, or the reverse.
- Using total sales rather than credit sales for receivable days, when credit sales are given.
- Quoting a ratio without saying what it means or comparing it.
- Treating a lower payable period as good without considering cash.
- Giving a percentage where the ratio is a number of times, or days.
Quick revision
- Margins: gross, operating and net, each ÷ sales.
- ROCE = PBIT ÷ (total assets − current liabilities). ROE = profit after tax ÷ equity.
- Days = average balance ÷ flow × 365. Operating cycle = inventory days + receivable days. CCC subtracts payable days.
- Margin is on sales, mark-up is on cost. Mark-up 25% = margin 20%.
- Always compare and explain.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one first.
Section A style: multiple choice
Question 1. Gross profit is ₦18m and sales are ₦45m. The gross profit margin is:
- 60%
- 25%
- 40%
- 150%
Show the answer
C. 18 ÷ 45 × 100 = 40%.
Question 2. Return on capital employed is:
- Profit before interest and tax ÷ (total assets − current liabilities)
- Profit after tax ÷ equity
- Sales ÷ total assets
- Gross profit ÷ sales
Show the answer
A. Option B is return on equity, C is asset turnover and D is gross margin.
Question 3. Profit before interest and tax is ₦6.75m and capital employed is ₦12.5m. ROCE is:
- 6.75%
- 18.5%
- 12.5%
- 54%
Show the answer
D. 6.75 ÷ 12.5 × 100 = 54%.
Question 4. Average inventory is ₦1,400,000 and cost of sales ₦14,400,000. Inventory days are about:
- 10.3
- 35.5
- 12.0
- 65.9
Show the answer
B. 1,400,000 ÷ 14,400,000 × 365 = 35.5 days.
Question 5. Receivables turnover is 12 times. Receivable days are:
- 12.0
- 24.3
- 30.4
- 36.5
Show the answer
C. 365 ÷ 12 = 30.4 days.
Question 6. Inventory days are 35.5, receivable days 30.4 and payable days 55.8. The cash conversion cycle is:
- 10.1 days
- 121.7 days
- 65.9 days
- 90.7 days
Show the answer
A. 35.5 + 30.4 − 55.8 = 10.1 days.
Question 7. Goods cost ₦80,000 and are sold at a mark-up of 25%. The selling price is:
- ₦60,000
- ₦100,000
- ₦105,000
- ₦20,000
Show the answer
B. 80,000 × 1.25 = 100,000.
Question 8. A mark-up of 25% on cost is a margin on sales of:
- 25%
- 33.3%
- 20%
- 75%
Show the answer
C. Profit is 25 on a selling price of 125, which is 20%.
Question 9. Operating profit is ₦6.75m and sales ₦45m. The operating profit margin is:
- 9.3%
- 40%
- 54%
- 15%
Show the answer
D. 6.75 ÷ 45 × 100 = 15%.
Question 10. The gross margin is stable but the net margin falls. The most likely cause is:
- Higher overheads or interest
- A higher selling price
- Cheaper materials
- A lower tax rate
Show the answer
A. Costs below gross profit, such as overheads and interest, have risen.
Section B style: written questions
Question 11 (10 marks). (a) Name the four categories of financial ratios and give one ratio from each. (4 marks) (b) Explain why a ratio should be compared with a benchmark. (6 marks)
Question 12 (20 marks). Katsina Mills Ltd reports (₦): year 1: sales 800,000, cost of sales 480,000, operating expenses 200,000, interest 20,000, total assets 900,000, current liabilities 150,000, equity 500,000. Year 2: sales 1,000,000, cost of sales 650,000, operating expenses 230,000, interest 40,000, total assets 1,200,000, current liabilities 250,000, equity 560,000. Tax is 25% of profit before tax.
(a) Calculate for both years the gross margin, operating margin, net margin, ROCE, ROE and asset turnover. (12 marks) (b) Comment on the change in performance. (8 marks)
A further written question
Question 13 (10 marks). Inventory was ₦60,000 at the start and ₦80,000 at the end, receivables ₦90,000 and ₦110,000, and payables ₦50,000 and ₦70,000. Cost of sales was ₦490,000, net credit sales ₦800,000 and credit purchases ₦500,000. (a) Calculate inventory days, receivable days and payable days using averages. (6 marks) (b) Calculate the operating cycle and the cash conversion cycle. (4 marks)
Model answers
Show the model answer to Question 11
(a) Profitability, such as gross profit margin. Liquidity or short-term solvency, such as the current ratio. Long-term solvency or stability, such as gearing. Shareholders’ ratios, such as earnings per share. (b) A single ratio has no meaning on its own. Comparing it with the previous period shows the trend, and comparing it with industry averages or similar businesses shows whether performance is good or poor.
It helps identify risks and opportunities, such as a falling margin or a lengthening collection period. Differences in size, accounting policies and business type should be considered.
Show the model answer to Question 12
(a) Year 1:
- gross profit 320,000, margin 40.0%.
- Operating profit 120,000, margin 15.0%.
- Profit before tax 100,000, tax 25,000, profit after tax 75,000, net margin 9.4%.
- Capital employed 750,000, ROCE 16.0%.
- ROE 75,000 ÷ 500,000 = 15.0%.
- Asset turnover 800,000 ÷ 900,000 = 0.89 times.
- Year 2: gross profit 350,000, margin 35.0%.
- Operating profit 120,000, margin 12.0%.
- Profit before tax 80,000, tax 20,000, profit after tax 60,000, net margin 6.0%.
- Capital employed 950,000, ROCE 12.6%.
- ROE 60,000 ÷ 560,000 = 10.7%.
- Asset turnover 1,000,000 ÷ 1,200,000 = 0.83 times.
(b) Sales grew by 25% but gross margin fell by five percentage points, so cost of sales grew faster than sales.
Operating profit did not increase, so the operating margin fell. Interest doubled, so borrowing increased. The business added assets and capital but earned no extra operating profit, so ROCE and ROE fell and asset turnover declined. The growth has been unprofitable.
Show the model answer to Question 13
(a)
- Average inventory.
70,000, so inventory days = 70,000 ÷ 490,000 × 365 = 52.1 days. - Average receivables.
100,000, so receivable days = 100,000 ÷ 800,000 × 365 = 45.6 days. - Average payables.
60,000, so payable days = 60,000 ÷ 500,000 × 365 = 43.8 days.
(b)
- Operating cycle.
52.1 + 45.6 = 97.8 days. - Cash conversion cycle.
97.8 − 43.8 = 54.0 days.
Pathfinder on Ratio analysis: profitability and efficiency
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. Gives opening inventory, purchases and closing inventory and a gross margin of 40%, and asks for the sales revenue for the year.
Revise first: Margin and mark-up
From the previous syllabus. A handset is sold for ₦250,000 at cost plus a mark-up of 20%, and the question asks for the profit.
Revise first: Margin and mark-up
From the previous syllabus. Gives opening and closing inventory, purchases and a profit margin of 5%, and asks for the gross profit.
Revise first: Margin and mark-up
Ratio analysis is a new syllabus item and no past diet asks for ratios such as ROCE or inventory days directly. Expect items on margins, mark-ups, ROCE and the efficiency ratios. Check Section A of every diet you practise.
Revise first: Profitability ratios
Source: ICAN Pathfinder, Financial Accounting. Diets covered: November Diet, 2014, May Diet, 2019 and May Diet, 2021. All are on the previous syllabus. Ratio analysis is a new syllabus item and no past diet asks for the main ratios directly. Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
Spotted a mistake? Tell us and we will check it.
