Analysis and interpretation (ii): liquidity, debt and investor ratios

A company can be very profitable and still fail, because it cannot pay its bills on time, or because it has borrowed so much that the interest eats its profit. Lenders ask whether they will be repaid. Shareholders ask what each share earns and whether the price is fair. This topic answers those questions with liquidity, debt and investor ratios.

It also covers why ratios can mislead and how to write an answer that scores.

This topic covers the current and quick ratios, gearing, interest cover, earnings per share (EPS), the price/earnings (P/E) ratio, dividend yield and cover, the limits of ratio analysis, creative accounting, related parties, non-financial information and exam technique. The previous topic covered common size analysis and performance ratios. The next topics cover other standards. November 2025 Question 3 and May 2026 Question 2 were reports on ratios.

Key terms in plain English

Syllabus check

Analysis and interpretation is examinable under syllabus area C. This topic covers:

• liquidity, gearing and investor ratios, and their meaning for each user;
• the limits of interpretation, creative accounting, and examination technique.

CAMA 2020 and ratio analysis

The Companies and Allied Matters Act 2020 (CAMA 2020) requires statements that follow International Financial Reporting Standards (IFRS) and give a true and fair view.

Liquidity ratios

• Current ratio = current assets ÷ current liabilities.
• Quick (acid test) ratio = (current assets − inventory) ÷ current liabilities. It is better when inventory is slow-moving.

Year-end balances are fine. There are no ideal figures: 2:1 and 1:1 are only rules of thumb, and some industries run on much less. Look at the trend and at the industry. In a group, liquidity ratios are averages and can hide a weak subsidiary.

Debt ratios

• Gearing = long-term debt ÷ (debt + equity), or the debt to equity ratio = debt ÷ equity. Include preference shares in debt. For a group, include the NCI in equity. A company is high-geared when debt exceeds equity (above 50% on the first measure, above 100% on the second).
• Interest cover = profit before interest and tax ÷ interest. Below about 3 times is low.

High gearing means less ability to borrow more and a greater risk of not paying lenders. Gearing and interest cover should be seen with cash flow.

Investor ratios

• EPS = earnings attributable to ordinary shareholders ÷ weighted-average shares (see the topic on EPS).
• P/E ratio = market price ÷ EPS. A high P/E shows confidence in growth; a low P/E shows low expectations.
• Dividend yield = dividend per share ÷ market price. It reflects the dividend policy and not the performance, and the price moves with expectations.
• Dividend cover = profit for ordinary shareholders ÷ ordinary dividends. A cover below about 2 suggests a dividend cut if profits fall.

Limits of ratio analysis

• Accounting policies: revaluation, depreciation methods, estimates and the provision or contingent liability choice differ. A policy change under International Accounting Standard (IAS) 8 is restated, but comparisons are still hard.
• Inflation: historical cost understates asset values and overstates profit. Current cost or current purchasing power accounting would give lower profit, lower asset turnover and a lower ROCE.
• Calculation methods: ROCE and gearing have several definitions.
• Comparability: companies differ in size, market segment (for example antiques against flat-pack furniture), and stage of the supply chain (supplier, manufacturer, retailer).
• Timing: year ends chosen at a quiet time give low inventory and receivables. A major purchase of assets near the year end raises capital employed before it earns profit. An acquisition at the year end brings in assets but not profit. Use monthly averages where possible.
• Historic information: statements are out of date when published, and show little about the future. Trends over several years help.
• Ratios give questions, not answers. Management strategy (for example cutting prices to win share) can explain a margin fall.
• Market values: some argue that market values and yields are more relevant than accounting returns.

Creative accounting and related parties

• Window dressing, off-balance-sheet finance (such as sale and repurchase), changes in policy or estimate (such as a revaluation to improve gearing), profit smoothing, aggressive revenue recognition and capitalising costs that are not assets.
• Most are now restricted by standards, but pressure grows when profits or cash fall or when bonuses depend on a measure such as EPS.
• Related party transactions are normal, but may not be on arm’s length terms (for example selling a property to a director’s company on favourable terms). They make profit and position less comparable.

Non-financial information

Statements show only what can be measured in money. Stakeholders also want to know about strategy, risks, environmental and social policies, research and unrecognised intangibles. A business review or management commentary supplies this. The International Accounting Standards Board’s Practice Statement on management commentary is not mandatory (see the later topic).

From 2027, IFRS 18 also adds rules on management-defined performance measures: they sit in one note and are reconciled to the statements.

The rules in more depth

Why a group’s ratios are hard to read

Debt and cash sit in different companies, so group liquidity and gearing are averages. A strong parent can hide a weak subsidiary.

Why inventory is excluded from the quick ratio

Inventory may take months to sell and may need a price cut. Cash and receivables are quicker.

Why a sale and repurchase matters

If the company has to buy the goods back, it has kept the risks and rewards. It is a loan. Showing it as a sale removes debt and raises profit.

Effect on analysis

A user who ignores these limits can rank a risky company above a sound one.

Worked examples

1. Gearing = 1,500 ÷ (1,500 + 3,600) = 29.4%.
2. Debt to equity.
   1,500 ÷ 3,600 = 41.7%.
3. Interest cover.
   700 ÷ 230 = 3.04 times, which is low.

1. EPS = 1,400,000 ÷ 1,200,000 = ₦1.17.
   P/E = 5.50 ÷ 1.1667 = 4.7.
2. Dividend per share.
   450,000 ÷ 1,200,000 = ₦0.375.
   Yield = 0.375 ÷ 5.50 = 6.8%.
3. Dividend cover.
   1,400,000 ÷ 450,000 = 3.1 times.
4. The low P/E suggests low expectations of growth. The cover is comfortable.

1. Gross margin. 30.0% and 30.0%.
   Operating profit = 800 − 560 − 120 = 120 and 960 − 672 − 162 = 126, so the operating margin is 15.0% and 13.1%.
2. ROCE.
   (closing) = 120 ÷ 630 = 19.0% and 126 ÷ 735 = 17.1%.
3. Inventory days 71.7 and 81.5. Receivables days 41.1 and 41.8. Payables days 71.7 and 67.9.
4. Interest cover.
   120 ÷ 20 = 6.0 and 126 ÷ 27 = 4.7.
   Gearing = 250 ÷ 630 = 39.7% and 300 ÷ 735 = 40.8%.
5. Drivers: overheads rose faster than revenue (15.0% to 16.9% of revenue), so the operating margin fell although gross margin held; inventory days rose by about ten, so stock is building; customers pay in about 41 days against 30-day terms; payables days of 68 are well beyond the 45-day terms (a risk with suppliers); extra debt financed assets, so ROCE and interest cover fell, but cover is still healthy.
6. Actions: cut stock lines and inventory days; control overheads; enforce the 30-day terms; refinance part of the debt with equity if gearing is a concern.

Note: ICAN’s solution calculates operating profit as profit before tax less finance costs (giving 10.0% and 7.5%), uses profit before tax for ROCE and for interest cover (giving 15.4% or 12.6%, and 5.0 and 3.7). Operating profit must add the finance costs back, so ours is slightly different from ICAN’s. The other ratios agree.

Also, the question’s Year 2 liabilities and equity add to ₦940m against assets of ₦960m, so use the data only for ratios.

1. A: Dr cost of sales 20; Cr inventory 20. B: Dr impairment loss (profit or loss) 15; Cr PPE 15.
2. C:
   present value = 22 × 3.9927 = 87.84.
   Dr right-of-use asset 87.84; Cr lease liability 87.84.
   Depreciation 87.84 ÷ 5 = 17.57 (Dr expenses).
   Interest 8% × 87.84 = 7.03 (Dr finance costs).
   Payment 22 (Dr lease liability; Cr cash).
   Liability at year end = 87.84 + 7.03 − 22 = 72.87 (current part about 16.17).
3. Revised profit:
   gross profit 340; expenses 180 + 15 + 17.57 = 212.57; profit before interest and tax 127.43; finance costs 43.03.
4. Revised position:
   inventory 210; cash 48; equity 540 − 20 − 15 − 17.57 − 7.03 = 480.40; debt = 300 + 72.87 = 372.87.
5. Ratios (draft to revised): gross margin 30.0% to 28.3%; ROCE 21.4% to 14.9% (127.43 ÷ 853.27); current ratio 2.04 to 1.75 (448 ÷ 256.17); quick ratio 1.08 to 0.93; gearing 35.7% to 43.7%; interest cover 5.0 to 3.0.
6. Every measure of profitability, liquidity and solvency weakens. A bank covenant on gearing or interest cover could be at risk.

Note: ICAN’s solution to this question uses a lease of ₦95m in the journal and ₦88m in the report, and gives revised ratios (gross margin 27.8%, current ratio 1.6, gearing 48.2%) that we could not reproduce from the data. The draft statement of financial position in the question is also ₦30m out of balance (assets ₦1,110m against ₦1,080m).

Our answer is slightly different from ICAN’s. In the exam, state your assumptions and show the working.

1. Currency: revenue in naira is inflated without more volume, so growth and ROCE look better than the real position.
2. Sale and leaseback: the one-off gain lifts profit and cash, but a new lease liability raises gearing and lowers interest cover later.
3. Held for sale: removes loss-making assets and results from the lines, flattering margins; the assets are current, which affects liquidity.
4. Inventory method: changes gross margin and inventory days, and reduces comparability.
5. Tax: a higher tax rate lowers net margin and EPS even if profit before tax is stable.
6. Each event should be linked to at least two ratio groups, and the one-off items stripped out when judging the trend.

1. In substance it is a loan secured on inventory. The company keeps the risks and rewards and must buy back.
2. Recorded as a sale, profit is overstated by ₦20m, inventory is lower and debt of ₦120m is left out. Gearing looks lower, and ROCE higher.
3. Correctly, inventory stays, and a liability of ₦120m is shown, with the ₦5m extra as finance cost over the period.

How to score full marks

• Read the requirement: who is the user, what do they want, and in what form (memo or report)?
• Review the statements before calculating: revaluations, new assets and how they were funded, acquisitions, loans repaid, share issues, unusual items, the year end and seasonality.
• Calculate a few well chosen ratios, with formulas, in an appendix.
• Look at absolute changes too (if sales rose 25%, inventory, receivables and payables should rise about the same).
• Give a reason for every observation and link points (for example, interest has not fallen although debt has, so debt may have been repaid just before year end).
• Structure the answer by the requirements, with headings such as profitability and solvency.
• List the further information you would want: share price, segment data, industry averages, policy changes, accounting policies.
• Use the company’s name, short sentences and bullets.

Common mistakes in the exam

• Calculating too many ratios and having no time to comment.
• Stating a change without a reason or a consequence.
• Choosing ratios that do not matter to the user.
• Comparing with a company of a different size, market or year end.
• Ignoring the information in the introduction.
• Missing the effect of an accounting treatment on the ratios (for example a sale and repurchase).
• Subtracting finance costs when finding operating profit.

Quick revision

• Current ratio, quick ratio, gearing, interest cover, EPS, P/E, dividend yield and cover.
• Group ratios are averages and include the NCI where relevant.
• Limits: policies, inflation, definitions, size, timing, history, creative accounting, related parties, non-financial matters.
• Explain every change and link the points.
• CAMA 2020: ss. 377(1), 378, 379 to 381, 374(1), 385, 404(7).

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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