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Using ratios to appraise performance and make projections

Edexcel IAL Accounting · WAC11 The Accounting System and Costing

Ratios are tools for judging a sole trader's or partnership's performance and for forecasting next year's figures. Exam questions ask you to calculate, compare, explain causes and recommend (spec 1.5.2 and 1.5.3).

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Appraising performance

Group the ratios: profitability, liquidity, asset use. For each, say whether it has improved or worsened, give a likely cause from the scenario and a consequence.

Ratio	Year 1	Year 2	Comment
Gross margin %	38.00	35.00	Worse: prices cut or buying costs up
Profit for the year %	13.50	12.50	Worse, partly from lower gross margin
ROCE %	19.20	17.39	Worse: less profit for each £1 of capital employed
Current ratio	1.90	2.00	Slightly better
Liquid ratio	1.10	1.08	Little change; about 1 : 1
Collection period (days)	38	45.62	Slower: credit control weaker
Payment period (days)	42	45.02	Paying suppliers more slowly
Inventory turnover (times)	8.60	7.80	Slower: inventory building up

Year 2 figures are the ones calculated in the previous two lessons

Making projections

To forecast, apply a target or expected ratio to a forecast figure:

Gross profit = forecast revenue x expected gross margin.
Trade receivables = forecast credit sales x target collection period / 365.
Trade payables = forecast credit purchases x payment period / 365.
Average inventory = forecast cost of sales / target inventory turnover.

State your assumptions: the ratio is assumed to stay the same, prices are stable, and so on.

Limitations of ratio analysis

Based on historical figures; the future may differ.
Year-end figures may not be typical (seasonal trade) or may be window dressed.
Different accounting policies (depreciation, inventory valuation) reduce comparability between businesses.
Inflation distorts comparisons over time.
Ratios show symptoms, not causes, and ignore non-financial factors: staff, reputation, the economy, competitors.

In evaluation questions use both the ratios and the non-financial information, and reach a conclusion.

Worked example

Next year revenue is expected to rise by 10% to £264,000, with the same gross margin. Credit sales stay at the same share of revenue, and the owner wants a collection period of 30 days and inventory turnover of 8 times. Project gross profit, trade receivables and average inventory.

Gross profit = 264,000 x 35% = 92,400; cost of sales = 171,600.
Credit sales = 220,000; receivables = x 30/365 = 18,082.
Average inventory = 171,600 / 8 = 21,450.

Answer: Gross profit £92,400; trade receivables about £18,082; average inventory £21,450.

Key idea: Appraise: calculate, compare, explain the cause, state the consequence, conclude. Project: forecast figure x expected ratio, stating assumptions.

Check yourself

Forecast revenue is £320,000 and the gross margin is expected to be 32%. Calculate forecast gross profit.
Show answer
£102400. 320,000 x 32% = 102,400.
Forecast credit sales are £219,000. The target collection period is 40 days. Calculate the forecast trade receivables.
Show answer
£24000. 219,000 x 40/365 = 24,000.
Forecast cost of sales is £180,000 and the target rate of inventory turnover is 9 times. Calculate the average inventory needed.
Show answer
£20000. 180,000 / 9 = 20,000.
Forecast revenue is £150,000 and goods are sold at a mark-up of 50%. Calculate forecast cost of sales.
Show answer
£100000. 150,000 / 1.5 = 100,000.
A sole trader's collection period has risen from 30 to 52 days. Which is the most likely cause?
- Suppliers have demanded faster payment
- Inventory is selling more slowly
- Gross margin has fallen
- Customers are being given longer to pay or are not being chased
Show answer
Customers are being given longer to pay or are not being chased. The collection period measures how quickly customers pay.
Which is a limitation of comparing two businesses' ratios?
- Ratios cannot be calculated for sole traders
- They may use different depreciation and inventory valuation methods
- Ratios always use cash figures
- Ratios include non-financial information
Show answer
They may use different depreciation and inventory valuation methods. Different accounting policies change the figures used.
Explain why a business owner should consider non-financial information as well as ratios before deciding to expand.
Show answer
Ratios are based on past figures and ignore factors such as staff skills, customer loyalty, competitors and the state of the economy, which could affect whether the expansion succeeds.. Say what ratios miss and give an example of a non-financial factor.

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Sources

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting specification (issue 2), Unit 1 and Appendices 6 to 8

Last updated 8 November 2026. Spotted a mistake? Tell us.