Module 1 of 2 · 60 minutes
Profitability, liquidity, efficiency and gearing
By the end of this module you will be able to
- Calculate the core ratios in each family
- Interpret a ratio against the right benchmark
- State the limitation of each ratio
- Spot period end window dressing
Amara One ratio, thirty seconds, a business you know nothing about.
Nadia Interest cover. Operating profit divided by interest payable. It answers whether the business earns enough to keep servicing its debt, and it is the first figure a lender turns to.
Amara The current ratio is taught as two to one.
Nadia From a textbook decades old, and repeated because it sounds authoritative. A supermarket runs far below it and is entirely sound, because it takes cash at the till and turns stock over in days.
Amara So the figure is meaningless without sector.
Nadia Without sector, and without a comparison. There are three worth making: this business last year, this business against its own budget, and this business against its sector. A ratio held up against a remembered rule of thumb is noise.
Amara How far can these figures be arranged?
Nadia Considerably, and mostly within the law. Year end is the thirty first of March. Hold supplier payments until the first of April and cash rises and the current ratio improves. Nothing underlying has changed; only which side of a date the payment landed.
Amara What exposes it?
Nadia A trend across several periods, and asking what moved in the fortnight either side of the date. A genuinely strong position looks strong continuously. An arranged one looks strong once a year.
Amara Return on capital employed. Why is it treated as the most complete profitability measure?
Nadia Because it holds management to what they were given. Operating profit over the capital in the business. Two firms each earning a million tell you nothing until you know one used five million to do it and the other fifty.
The written material
Why ratios exist
An absolute number carries no meaning without a denominator. Profit of two million pounds is exceptional on ten million of capital employed and dismal on two hundred million. The ratio supplies the denominator.
Ratios fall into four families answering four questions: are we making money, can we pay what falls due, are we using our assets well, and how much of this business is funded by debt.
Reading them honestly
Every ratio needs a comparison to mean anything, and there are only three worth using: the same business in the prior period, the budget it set itself, and its own sector. A ratio compared to a remembered textbook figure is noise.
Sector matters more than people expect. A supermarket runs on liquidity figures that would terrify a manufacturer, because it takes cash at the till and sells its stock in days, while the manufacturer waits months for both.
What a ratio cannot see
Ratios are calculated from a single date or a single period, and both can be arranged. Delaying supplier payments until after the year end improves the cash figure and the current ratio without anything real having changed. Pushing a delivery into the next period reduces stock days.
None of this is necessarily fraudulent, and much of it is ordinary year end housekeeping. It is simply a reason to read a trend across several periods rather than one immaculate snapshot, and to ask what happened in the fortnight either side of the date.
Knowledge check
The knowledge check and your certificate need a free account, so that your progress and results can be saved as evidence.
The learning itself stays free and open. You are reading all of it right now without an account.