Financial statements give figures; ratios give meaning. A profit of ₦105 million is good news for a small company and a disaster for a large one, and only by relating it to sales, to the capital invested or to last year does it tell a reader anything.
Financial analysis is the technique of turning the numbers into measures that can be compared. The interpretation of those measures is the skill the examiners test most often in the longer questions on performance.
This topic covers the purpose of ratio analysis, the comparisons that make a ratio useful, the categories of ratios, and then the first group: the ratios of return and profitability, including return on capital employed, return on shareholders’ capital, return on assets, profit margins, asset turnover and sales growth, with the adjustments for groups. The next topic covers working capital efficiency and liquidity.
Ratio analysis is a regular examination topic. In November Diet, 2023, Question 2 (20 marks) asked candidates to adjust the financial statements of a company that a client wished to buy, recalculate profitability ratios against sector averages and write a memo to the managing director (10 marks for the calculations and 10 marks for the memo).
In May Diet, 2026, Question 3 (20 marks) asked for return on capital employed, earnings per share, dividend per share, dividend cover and asset turnover over four years, followed by advice to an investor. Read group disclosures, management commentary and the application of the standards in group scenarios first.
In 30 seconds
Ratio analysis relates figures in the financial statements to each other so that position and performance can be judged over time, against competitors and against the industry. The ratios fall into profitability and return, working capital efficiency, liquidity, solvency and investors’ groups. Return on capital employed = profit before interest and tax ÷ (equity + long-term debt) × 100. Return on shareholders’ capital = profit after tax (and preference dividends) ÷ equity × 100.
Return on assets = profit before interest and tax ÷ total assets. Return depends on profit margin and asset turnover: return on capital employed = margin × asset turnover. For a group, capital employed includes the non-controlling interest, but return on shareholders’ capital uses profit and equity attributable to the parent’s owners.
The purpose of ratio analysis
Users of financial statements want to know how well the business is doing and how safe it is. Ratio analysis turns the statements into percentages and multiples that can be compared. A ratio on its own proves little. It becomes useful when compared with:
- the same entity in earlier periods, to see the trend;
- other entities, particularly competitors, for the same period;
- the industry average; and
- a target or budget, or a benchmark such as the cost of borrowing.
Other forms of analysis include horizontal analysis (percentage change from one year to the next), vertical analysis (each line as a percentage of a base such as revenue or total assets) and trend analysis over several years. The ratios themselves are grouped by what they are meant to show:
- Profitability and return: how much profit relative to sales and to capital;
- Working capital efficiency: how quickly receivables, inventory and payables turn over;
- Liquidity: ability to pay short-term debts;
- Solvency and gearing: reliance on debt and ability to service it;
- Investors’ ratios: earnings, dividends and share price.
The example company
Topics 57 to 62 use one company, Zaria Plc, with these figures (₦ million) for Year 2 and Year 1.
| Year 2 | Year 1 | |
|---|---|---|
| Revenue | 1,200 | 1,000 |
| Cost of sales | (720) | (600) |
| Gross profit | 480 | 400 |
| Operating expenses | (300) | (240) |
| Profit before interest and tax | 180 | 160 |
| Finance costs | (30) | (20) |
| Profit before tax | 150 | 140 |
| Tax | (45) | (42) |
| Profit after tax | 105 | 98 |
| Non-current assets | 900 | 760 |
| Inventory | 150 | 110 |
| Trade receivables | 200 | 140 |
| Cash | 50 | 90 |
| Total assets | 1,300 | 1,100 |
| Share capital (₦1 shares) | 200 | 200 |
| Retained earnings | 520 | 457 |
| Long-term loans | 330 | 250 |
| Trade payables | 210 | 160 |
| Tax payable | 40 | 33 |
| Total equity and liabilities | 1,300 | 1,100 |
Dividends paid were ₦42 million in Year 2 and ₦39 million in Year 1, and the share price at the end of Year 2 is ₦6.30. The ratios below use year-end figures, which is acceptable if the question gives only two balance sheets. Where a question gives opening balances, average capital employed (opening plus closing, divided by two) is preferred.
Return on capital
Return on capital employed (ROCE) = profit before interest and tax ÷ capital employed × 100, where capital employed is share capital and reserves plus long-term debt capital (including preference shares). It shows how well the business uses all the long-term finance. For Zaria: Year 2, ₦180m ÷ (₦720m + ₦330m) = 180 ÷ 1,050 = 17.1%; Year 1, 160 ÷ (657 + 250) = 160 ÷ 907 = 17.6%.
The ratio is compared with previous years, with competitors and with the cost of borrowing: a return below the interest rate on the loans would be a warning.
Return on shareholders’ capital (return on equity) = profit after tax (and preference dividends) ÷ share capital and reserves × 100. It measures what the owners earn on their investment. Year 2: 105 ÷ 720 = 14.6%; Year 1: 98 ÷ 657 = 14.9%.
Return on assets = profit before interest and tax ÷ total assets. Year 2: 180 ÷ 1,300 = 13.8%; Year 1: 160 ÷ 1,100 = 14.5%. Some analysts use non-current assets only.
Groups
For a group, capital employed should include the non-controlling interest, because profit before interest and tax is the profit of the whole group, including the part that belongs to outsiders. Return on shareholders’ capital, on the other hand, is about the parent’s owners: use profit after tax and non-controlling interest over equity attributable to the owners of the parent, without the non-controlling interest.
Profitability and asset utilisation
The size of the return depends on two things: how profitable each naira of sales is, and how many naira of sales are made for each naira of capital. These are the profit margin and the asset turnover.
- Gross profit margin. = gross profit ÷ revenue.
Year 2 480 ÷ 1,200 = 40.0%
Year 1 400 ÷ 1,000 = 40.0%.
Useful for comparison within an industry. - Operating (PBIT) margin. = profit before interest and tax ÷ revenue.
Year 2 180 ÷ 1,200 = 15.0%
Year 1 160 ÷ 1,000 = 16.0%. - Net profit margin. = profit after tax ÷ revenue.
Year 2 105 ÷ 1,200 = 8.75%
Year 1 98 ÷ 1,000 = 9.8%. - Expenses to revenue.
operating expenses ÷ revenue: 300 ÷ 1,200 = 25% against 240 ÷ 1,000 = 24%. - Asset turnover. = revenue ÷ capital employed (or total assets).
Year 2 1,200 ÷ 1,050 = 1.14 times
Year 1 1,000 ÷ 907 = 1.10 times. - Percentage growth in sales.
(this year − last year) ÷ last year: (1,200 − 1,000) ÷ 1,000 = 20%.
Check: ROCE = PBIT margin × asset turnover = 15.0% × 1.143 = 17.1%. A high gross margin with a low net margin suggests heavy overheads. Zaria’s gross margin is unchanged but its PBIT margin fell by one percentage point, because expenses rose faster than sales (25% against 24% of revenue). Return fell slightly in spite of faster asset turnover, so the extra sales did not repay the extra cost.
The ideas in more depth
Why the definition must be stated
“Profit” and “capital employed” can each be defined in several ways. The ratio is meaningful only if the same definition is used for each year and each entity, and stated in the answer. Using profit before interest and tax for capital employed that includes debt, and profit after tax for equity only, keeps the numerator in line with who provided the capital.
Why average capital is better
Profit is earned over the year, while the year-end balance is a snapshot. If capital grew late in the year the year-end figure would understate the return on the capital used for most of it. The average of opening and closing balances is closer to what was available during the year.
Sources and references
- International Accounting Standard (IAS) 1 Presentation of Financial Statements and IAS 33 Earnings per Share for the underlying figures; the definitions of the ratios are conventional analytical measures, not set by a standard.
These points are stated as at 5 November 2026.
Worked examples
Example 1: the return ratios. Use the Zaria figures. Required: ROCE, return on shareholders’ capital and return on assets for Year 2.
- ROCE.
180 ÷ (720 + 330) = 180 ÷ 1,050 = 17.1%. - Return on shareholders’ capital.
105 ÷ 720 = 14.6%. - Return on assets.
180 ÷ 1,300 = 13.8%.
Example 2: why the return fell. Required: explain the change in ROCE from 17.6% to 17.1%.
- Margin. PBIT margin fell from 16.0% to 15.0%.
- Turnover. Asset turnover rose from 1.10 to 1.14 times.
- Conclusion. The fall in the margin outweighed the improvement in turnover, because operating expenses rose to 25% of revenue.
Example 3: a group. A group has profit before interest and tax of ₦400m, equity attributable to the parent’s owners of ₦1,500m, non-controlling interest of ₦300m and long-term debt of ₦700m. Required: capital employed.
- Capital employed.
₦1,500m + ₦300m + ₦700m = ₦2,500m, including the non-controlling interest. - ROCE.
₦400m ÷ ₦2,500m = 16%.
How to answer in the exam
- State the formula for each ratio, then show the substitution.
- Be consistent in the definition of profit and capital for every year.
- Comment on each ratio: the direction, the likely cause and what it means for the user.
- Use the comparison the question gives: previous years, a competitor or the sector average.
Common mistakes in the exam
- Using profit after tax in return on capital employed.
- Leaving out the long-term debt in capital employed.
- Excluding the non-controlling interest from group capital employed.
- Calculating ratios without commenting on them.
- Mixing definitions between years.
- Calculating the percentage to the wrong base (for example growth on the current year).
Quick revision
- ROCE = PBIT ÷ (equity + long-term debt). Return on shareholders’ capital = profit after tax ÷ equity. Return on assets = PBIT ÷ total assets.
- ROCE = PBIT margin × asset turnover.
- Group: capital employed includes NCI; return on shareholders’ capital excludes it.
- Compare over time, with competitors and with the industry.
Practice questions
These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.
Recall check: multiple choice
Question 1. A ratio is most useful when it is:
- Calculated once
- Used without any comparison
- Compared over time, with competitors and with the industry
- Compared only with its formula
Show the answer
C. Comparison gives the figure meaning.
Question 2. Return on capital employed is:
- Profit after tax ÷ equity
- Profit before interest and tax ÷ (equity + long-term debt)
- Profit ÷ revenue
- Revenue ÷ assets
Show the answer
B. Capital employed is equity plus long-term debt.
Question 3. Return on shareholders’ capital uses:
- Profit after tax and preference dividends ÷ share capital and reserves
- PBIT ÷ total assets
- Gross profit ÷ revenue
- Revenue ÷ equity
Show the answer
A. It measures the owners’ return.
Question 4. Asset turnover is:
- Profit ÷ revenue
- Profit ÷ assets
- Assets ÷ revenue
- Revenue ÷ capital employed (or assets)
Show the answer
D. It shows how hard the assets work.
Question 5. ROCE equals:
- Margin + turnover
- PBIT margin × asset turnover
- Margin ÷ turnover
- Gross margin only
Show the answer
B. (PBIT ÷ revenue) × (revenue ÷ capital employed).
Question 6. A high gross margin with a low net margin suggests:
- High overhead costs
- Low sales
- Low inventory
- High tax only
Show the answer
A. Administrative, selling and distribution costs.
Question 7. For a group, capital employed:
- Excludes the NCI
- Is the parent’s only
- Includes the non-controlling interest
- Is nil
Show the answer
C. The profit used is the whole group’s.
Question 8. Percentage growth in sales is:
- New sales ÷ old sales
- Profit ÷ sales
- Sales ÷ assets
- (This year − last year) ÷ last year
Show the answer
D. On the earlier year as the base.
Question 9. Average capital employed is preferred because:
- It is easier
- It is required by law
- Profit is earned over the year, not at the year end
- It is higher
Show the answer
C. A snapshot may misstate the capital used.
Question 10. Horizontal analysis shows:
- The percentage change from one year to the next
- Each line as a percentage of total assets
- The ratio to the industry
- Only cash
Show the answer
A. Vertical analysis shows lines as a percentage of a base.
Section B style: written questions
Question 11 (10 marks). (a) State the purpose of ratio analysis and THREE comparisons that make a ratio useful. (5 marks) (b) State the formulas for return on capital employed and return on shareholders’ capital. (5 marks)
Question 12 (15 marks). A company has revenue of ₦800m, gross profit of ₦320m, profit before interest and tax of ₦120m, finance costs of ₦20m, tax of ₦30m, equity of ₦500m and long-term loans of ₦200m. (a) Calculate gross margin, PBIT margin and net margin. (6 marks) (b) Calculate ROCE and return on shareholders’ capital. (4 marks) (c) Calculate asset turnover on capital employed and show that ROCE equals margin × turnover. (5 marks)
A further written question
Question 13 (20 marks). Year 2 revenue is ₦900m (Year 1 ₦750m), PBIT ₦135m (Year 1 ₦120m), capital employed ₦600m (Year 1 ₦500m) and operating expenses ₦180m (Year 1 ₦150m); gross profit is ₦315m (Year 1 ₦270m).
(a) Calculate for both years the gross margin, PBIT margin, ROCE, asset turnover and growth in sales. (10 marks) (b) Comment on the trend in profitability and the reasons for it. (6 marks) (c) State TWO limitations of comparing the ratios with a competitor’s. (4 marks)
Model answers
Show the model answer to Question 11
(a) Ratio analysis relates figures in the financial statements to each other so that position and performance can be assessed (2). Comparisons: with previous periods (1), with other entities for the same period (1), and with the industry average (1).
(b)
- ROCE = profit before interest and tax ÷ (share capital and reserves + long-term debt) × 100 (2.5).
- Return on shareholders’ capital = profit after tax (and preference dividends) ÷ share capital and reserves × 100 (2.5).
Show the model answer to Question 12
(a)
- Gross margin 320 ÷ 800 = 40.0% (2).
- PBIT margin 120 ÷ 800 = 15.0% (2).
- Net profit.
120 − 20 − 30 = 70 - 70 ÷ 800 = 8.75% (2).
(b)
- Capital employed ₦500m + ₦200m = ₦700m.
- ROCE 120 ÷ 700 = 17.1% (2).
- Return on shareholders’ capital 70 ÷ 500 = 14.0% (2).
(c)
- Asset turnover 800 ÷ 700 = 1.14 times (2).
- Margin × turnover.
15.0% × 1.143 = 17.1% = ROCE (3).
Show the model answer to Question 13
(a)
- Year 2: gross margin 315 ÷ 900 = 35.0%
- PBIT margin 135 ÷ 900 = 15.0%
- ROCE 135 ÷ 600 = 22.5%
- asset turnover 900 ÷ 600 = 1.5 times
- growth (900 − 750) ÷ 750 = 20.0%.
- Year 1: gross margin 270 ÷ 750 = 36.0%
- PBIT margin 120 ÷ 750 = 16.0%
- ROCE 120 ÷ 500 = 24.0%
- asset turnover 750 ÷ 500 = 1.5 times (10).
(b) Profitability has fallen: ROCE from 24.0% to 22.5% (1.5). Turnover was unchanged at 1.5 times, so the fall comes entirely from the margin (1.5). Gross margin fell by one point, suggesting higher costs of sales or lower prices (1.5), and the PBIT margin fell by one point, so overheads grew in line with the gross profit fall (1.5). Sales grew by 20%, but the growth was achieved at lower margins (1).
(c) Competitors may use different accounting policies (2). They may have a different financial year, size or business mix (2).
Pathfinder on Financial analysis (i): purpose, return and profitability ratios
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.
The question asks for adjusted financial statements and recalculated profitability ratios against sector averages (10 marks) and a memo to the managing director commenting on performance (10 marks).
Revise first: Profitability and asset utilisation
Part (a) asks for return on capital employed, earnings per share, dividend per share, dividend cover and asset turnover for four years (5 marks); the return and turnover ratios belong to this topic.
Revise first: Return on capital
Source: ICAN Pathfinder, Financial Reporting. Diets covered: Every diet in the Pathfinder, from November Diet, 2021 to May Diet, 2026, was reviewed here. The diets listed above test this topic directly..
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