Ratio Analysis

Start with a question

Northstar's revenue rose, but what did that growth mean for the business? Examine margins, asset use and cash conversion, then consider whether the business can continue to finance its growth.

Condensed data, £000

2026 purchases are £380,000: cost of sales £360,000 + closing inventory £100,000 − opening inventory £80,000. Capital expenditure is £80,000.

Set the measurement rules first

Use the same currency scale and accounting period in each comparison. A margin compares two period flows; a current ratio compares two balances at the same date. Returns and turnover compare a period flow with the resources used to generate it, so an average balance is usually more informative than a single closing balance. Here the average is opening plus closing divided by two; a seasonal business may need monthly averages.

Define each ratio before comparing it: does debt mean interest-bearing borrowings or all liabilities, and which assets count as quick assets? The name alone may not tell you. If a denominator is zero, report the ratio as undefined. Negative or very small equity can also make ROE misleading, so explain the underlying balances before using the result to rank performance.

1. Profitability: locate the layer

Do not stop at “margin improved.” Gross margin fell while operating margin rose. Investigate price, mix, component costs, production efficiency and operating-cost scale separately.

Turn a percentage into an explanation

Northstar's gross profit rose from £210,000 to £240,000, but revenue grew faster: 20.0% versus gross profit growth of 14.3%. Consequently, gross margin fell from 42% to 40%: 2 percentage points, or a 4.8% decline relative to the old margin. These are different descriptions, so name the unit.

At the old 42% margin, £600,000 of revenue would produce £252,000 of gross profit. Actual gross profit is £12,000 below that benchmark. The gap gives you a specific amount to investigate, but does not by itself establish overspending: selling prices, product mix and input costs could each explain part of it.

2. Liquidity: inspect composition

There is no universal “healthy 2:1.” A supermarket and a project contractor have different working-capital cycles. To interpret the ratio, check receivable ageing, inventory saleability, seasonality, unused facilities and when liabilities fall due.

3. Working-capital cycle: use the right flow

Using averages for 2026 and total sales as a disclosed proxy because credit-sales data is unavailable:

Use credit sales for DSO and credit purchases for DPO when available. Total sales and cost of sales are proxies, not automatically correct denominators.

The estimate of 68.8 days does not establish a trend: without the 2024 opening balances, we cannot calculate a comparable figure for the preceding year. Describe it as a “current estimate,” rather than concluding that the cycle has “deteriorated.”

4. Returns: decompose ROE

Using average assets of £465 and average equity of £175:

ROE combines operations and financing. A higher equity multiplier can lift ROE while also increasing risk.

5. Cash cross-check

• Operating cash flow / net income = 65 / 60 = 1.08.
• A common management-defined free-cash-flow proxy is CFO − capex = 65 − 80 = −£15,000.

Both results need further interpretation:

• CFO can exceed profit because of depreciation or temporary working-capital movements.
• Negative free cash flow can indicate growth investment or distress.
• “Free cash flow” is not a single IFRS/US GAAP subtotal; define and reconcile it.

Recalculate and stress-test

Real-report check

Unilever’s 2025 Annual Report reported turnover down 3.8% while underlying sales growth was positive, with currency and portfolio effects explaining much of the difference. This is a useful lesson:

• reported growth and management-defined growth answer different questions;
• a non-GAAP measure requires definition and reconciliation;
• volume, price, currency and disposals should not be collapsed into one label.

Research also warns against one universal earnings-quality proxy. Dechow, Ge and Schrand’s review concludes that quality depends on the decision context; Sloan’s accrual study motivates separating cash and accrual components rather than blindly “trusting cash.”

A five-sentence analysis template

1. State the movement and comparison.
2. Decompose the numerator and denominator.
3. Link the movement to an operational hypothesis.
4. Cross-check cash, notes and accounting policy.
5. State missing evidence and the next test.

For example: “Gross margin fell 2 percentage points despite higher gross profit. Revenue grew faster than gross profit, leaving £12,000 less gross profit than a constant-margin benchmark. A shift toward lower-margin models is one possible explanation. I would compare model-level prices, volumes and unit costs, then check inventory valuation. Those data are not supplied, so the cause remains a hypothesis.” Apply the same method to the comparative-ratio exercise.

For collection and payment denominator conventions, see ACCA's working-capital analysis.

Quick check

Can you conclude that Northstar collected customers more slowly in 2026 because DSO is 47.1 days?

Next: IFRS versus US GAAP