Cambridge IGCSE0450

Analysis of accounts

Business Studies 0450 Chapter Notes

What this chapter covers

Analysis of accounts - ProfitabilityAnalysis of accounts - LiquidityAnalysis of accounts - How to interpret the financial performance of a business by calculating and analysing profitability ratios and liquidity ratiosAnalysis of accounts - Why and how accounts are used

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1. Profit and profitability

Profit is the money left when a business's total costs are taken away from its revenue. It is an amount of money, such as textdollar30 000.

Profitability measures profit compared with another figure, such as revenue. One measure is the profit margin: profit as a percentage of revenue.

Because it is a percentage, profitability lets an owner compare one year with another, or the business with a competitor. A business can make more profit and still be less profitable.

Examiner insight

“A common error was to describe profit or cash flow rather than profitability and liquidity.” “Very few candidates made use of the figures provided to calculate profitability and then realise that whilst profit was increasing profitability was falling.”

Worked example 14 marks

Marlow Kayaks hires out kayaks on a lake. Last year its revenue was textdollar150 000 and its profit was textdollar30 000. The owner, Jo, thinks profit and profitability mean the same thing. Outline the difference between the profit and the profitability of Marlow Kayaks.

1
Knowledge: profit is revenue minus total costs. It is an amount of money. [1]
2
Application: Marlow Kayaks made textdollar30 000 from hiring out kayaks. [1]
3
Knowledge: profitability is profit compared with revenue, written as a percentage. [1]
4
Application: 30 000 ÷ 150 000 × 100 = 20%, so 20 cents of each dollar of hire revenue is profit. [1]

2. Profit as a source of funds

Profit that the owners keep in the business can be reinvested, for example to buy new equipment. It finances investment. It does not pay the running costs, because profit is what is left after those costs.

It is a source of funds with no interest to pay. A bank loan has to be repaid with interest, so profit is cheaper. It can allow the business to expand.

A new business has made no profit yet, so it has none to reinvest.

Examiner insight

“A large number of responses did not demonstrate knowledge of the meaning of profit and suggested that profit would help to pay for the costs of running the business. Although the strongest candidates were aware that profit could be reinvested to provide funds for the business, very few could correctly apply this information in the context of this business.” “Some ignored the fact that this was a new business and therefore did not have access to some sources such as retained profits.”

Worked example 16 marks

Greenfield Bakery sells bread and cakes in a town centre. It made a profit of textdollar18 000 last year. The owner wants a second oven that costs textdollar15 000. Explain two advantages to Greenfield Bakery of paying for the oven from its profit instead of a bank loan.

1
Knowledge: there is no interest to pay on profit that is reinvested. [1]
2
Application: the textdollar15 000 oven can be paid for from the textdollar18 000 profit. [1]
3
Analysis: a bank loan would add interest to the bakery's costs, so its future profit would be lower. [1]
4
Knowledge: the profit is already in the business, so it is available straight away. [1]
5
Application: the bakery can start making more bread and cakes without waiting for a bank to agree. [1]
6
Analysis: output rises sooner, which allows the bakery to expand and sell more. [1]

3. Profit as a measure of success and a reward

Profit is a measure of success. A low profit could suggest the business is not worth continuing.

It is a reward for risk-taking. The reward goes to the owners or shareholders who invested, not to the employees. It can be paid as dividends. Without this return they could invest elsewhere.

A healthy profit helps to attract investors, who hope for a return on their money. A business can also share profit with employees, which could increase motivation.

Examiner insight

“The first option also had repetition of the question with candidates saying profit was a reward for risk taking as they had taken a risk and therefore deserved a reward. Weaker candidates also seemed to be confused over who was getting the reward and spoke of the reward for employees.”

Worked example 16 marks

Explain two reasons why profit might be important to a business. Which reason is likely to be the most important? Justify your answer.

1
Knowledge: profit is a source of funds, as it can be reinvested back into the business. [1]
2
Analysis: there is no interest to pay, and it allows the business to expand. [1]
3
Knowledge: profit is a measure of success. [1]
4
Analysis: a low profit could suggest the business is not worth continuing. [1]
5
Evaluation: a decision, such as: providing a source of funds is likely to be the most important. [1]
6
Evaluation: a reason that compares the two, such as: funds with no interest to pay let the business expand, while success can be measured in other ways. [1]

4. Why profitability matters

Profit in dollars can mislead. Profit can rise while profitability falls, when costs grow faster than revenue. If costs and revenue rise in the same proportion, profit rises but profitability stays the same.

Profitability is used to judge how well a business is performing. A bank looks at it to decide whether a loan can be repaid. Investors look at it before they buy shares, because falling profitability makes increased dividends less likely.

A good answer calculates profitability as a percentage, compares the figures, and ends with a recommendation and a reason. Stating that profitability has fallen is not enough.

Examiner insight

“Recommendations did not often go beyond stating that profitability had fallen and Peter should be worried.” “However, there were some issues where the GPM and NPM were written as fractions or as 0.25 and not as a percentage.”

Worked example 16 marks

Zoya runs Zip Zone, a zip-wire park. Zoya says: 'Profit has risen, so the business is doing better.' Do you agree? Justify your answer.

	Revenue	Profit
Last year	textdollar200 000	textdollar40 000
This year	textdollar300 000	textdollar45 000

1
Knowledge: profit is a measure of success. [1]
2
Knowledge: profitability compares profit with revenue. [1]
3
Analysis: profit rose by textdollar5 000, so by this measure Zip Zone is doing better. [1]
4
Analysis: the profit margin fell from 20% (40 000 ÷ 200 000) to 15% (45 000 ÷ 300 000), so costs rose faster than revenue. [1]
5
Evaluation: a decision, such as: Zoya is only partly right. [1]
6
Evaluation: a reason, such as: the park earns more profit, but each dollar of revenue now earns 15 cents instead of 20, so Zoya should find out why costs rose. [1]

Recap

Profit is revenue minus total costs: an amount of money.
Profitability compares profit with another figure, such as revenue, as a percentage.
A business can make more profit and still be less profitable.
Reinvested profit is a source of funds with no interest to pay, and can allow a business to expand.
Profit is a measure of success and a reward for risk-taking, paid to owners as dividends.
Banks and investors use profitability to judge a business before they lend or buy shares.
Calculate profitability as a percentage, compare, then recommend with a reason.

5. What liquidity means

Liquidity is the speed at which a business's assets can be turned into cash. It tells you whether the business is able to pay its short-term debts.

A definition must be precise. Do not describe cash flow. Do not state a liquidity ratio in place of the meaning.

Think of liquidity as a safety net of cash for paying debts or a loan.

Examiner insight

“Many candidates understood that liquidity referred to the speed at which assets could be turned into cash.” “However, many candidates did not understand what liquidity is in relation to having a safety net of cash for payment of debts or a loan.”

Worked example 12 marks

Ruby runs Ruby's Repairs, a shop that fixes phones. Her accountant tells her to watch the shop's liquidity. Define 'liquidity'.

1
Knowledge: the speed at which assets can be turned into cash. [1]
2
Knowledge: the ability of a business to pay its short-term debts. [1]

6. Liquidity is not profit or cash flow

Liquidity is about whether a business can pay its short-term debts. It is not a measure of profit, and it is not the same thing as cash flow.

A business can be profitable and still have a liquidity problem. A rise in revenue or sales does not show that its liquidity is good.

Examiner insight

“A common error was to describe profit or cash flow rather than profitability and liquidity.” “Some candidates wrongly assumed that liquidity is used to measure profit.”

Worked example 14 marks

Orchard Café serves lunches in a town centre. It made a profit of textdollar30 000 last year. It now has textdollar400 in cash and a supplier bill of textdollar2 500 due this week. Explain why the café could have a liquidity problem even though it made a profit.

1
Knowledge: liquidity is the ability to pay short-term debts. It does not measure profit. [1]
2
Application: the café has only textdollar400 in cash against a textdollar2 500 bill due this week. [1]
3
Analysis: it is textdollar2 100 short, so it cannot pay its supplier on time. [1]
4
Analysis: the textdollar30 000 profit was made over last year and is not the cash it holds now, so a profitable café can still have a liquidity problem. [1]

7. Why liquidity matters

A business with enough liquidity can pay its short-term debts on time. Paying suppliers and paying wages are both day-to-day costs, so they count as one reason, not two.

A business without enough liquidity may have to sell its assets to find the cash. Liquidity lets it avoid this.

Examiner insight

“Good responses explained that liquidity was important to enable short-term debts to be repaid to avoid selling business assets.” “For example, paying wages and paying suppliers are both examples of day-to-day costs so this is classed as repetition.”

Worked example 16 marks

Zed Bakery owes its flour supplier textdollar3 000, due in 30 days. It has textdollar500 in cash and two large ovens. Explain two reasons why liquidity is important to Zed Bakery.

1
Knowledge: liquidity lets a business pay its short-term debts on time. [1]
2
Application: Zed Bakery must find textdollar3 000 for its flour supplier within 30 days. [1]
3
Analysis: if it cannot pay, the supplier may stop delivering flour, so it cannot bake. [1]
4
Knowledge: liquidity lets a business avoid selling its assets. [1]
5
Application: with only textdollar500 in cash, Zed Bakery may have to sell one of its two ovens. [1]
6
Analysis: with one oven it bakes less, so its sales fall. [1]

8. Low liquidity and lenders

A lender wants to know that a loan will be repaid. A business with reduced liquidity is in danger of not being able to meet its short-term debts.

Even if the business is profitable, a bank manager is unlikely to lend to one with a liquidity problem.

Examiner insight

“Better candidates identified in the recommendation that the business had reduced liquidity and was in fact in danger of not being able to meet short-term debts.” “Stronger answers linked the figures in the cash-flow forecast to CC having a liquidity problem and therefore would find it difficult to gain a bank loan to expand.”

Worked example 14 marks

Lantern Books is profitable. It wants a textdollar30 000 bank loan. It has textdollar1 000 in cash and textdollar9 000 of bills due next month. Explain why the bank might refuse the loan.

1
Knowledge: the bank wants to know that the business can pay its short-term debts. [1]
2
Application: Lantern Books has textdollar1 000 in cash against textdollar9 000 of bills due next month. [1]
3
Analysis: it may not meet its bills, so the bank fears the loan will not be repaid either. [1]
4
Analysis: so the bank may refuse the loan, even though the shop is profitable. [1]

9. Judging liquidity: the current ratio

A business can judge its liquidity position by calculating a ratio. The current ratio compares current assets with current liabilities.

Use the current figures only. Total assets and total liabilities are the wrong figures. Write the answer as a ratio, not as a monetary value.

Label the ratio with its name when you write it down.

current ratio = current assets : current liabilities

Examiner insight

“However, one error was to write the ratios as a monetary value and another error was to express the ratio as total assets and liabilities rather than current assets and liabilities.”

Worked example 12 marks

BTV's 16 factories use flow production to manufacture cars. The managing director is reviewing BTV's financial data including profit. An extract is in Table 3.1. Calculate BTV's current ratio. Show your working.

Extract from BTV's financial data - December 2025 ($ million)
non-current assets	700
current assets	90
current liabilities	120
non-current liabilities	300
profit	900

1
Knowledge: current ratio = current assets : current liabilities = 90 : 120 [1]
2
Application: = 0.75 : 1 [1]

Recap

Liquidity: the speed at which assets can be turned into cash, and the ability to pay short-term debts.
Liquidity is not profit and it is not cash flow.
A profitable business can still have a liquidity problem.
Liquidity lets a business pay its short-term debts and avoid selling its assets.
A bank is unlikely to lend to a business with a liquidity problem.
Current ratio = current assets : current liabilities, written as a ratio.
Every point names the business and says what happens next.

10. Gross profit margin

Gross profit margin is gross profit as a percentage of revenue. It shows how much of every dollar of sales is left after paying the cost of sales.

Gross profit is revenue minus cost of sales. A higher margin means the business keeps more from each sale, because it charges higher prices or buys or makes its goods more cheaply.

A lower margin points to a lower price or a higher cost of sales. Expenses such as rent and salaries do not change it.

gross profit = revenue - cost of sales

gross profit margin = (gross profit)/revenue × 100%

Examiner insight

“A common mistake was to place the values for revenue and gross profit in the wrong order when attempting to calculate gross profit margin.” “A common mistake was to assume that expenses including rent and salaries would have an impact on gross profit.”

Worked example 12 marks

Rafi's Rugs is a small shop in Lahore selling hand-woven rugs. Last year its revenue was textdollar80 000 and its cost of sales was textdollar50 000. Calculate Rafi's Rugs' gross profit margin. Show your working.

1
Knowledge: gross profit = revenue − cost of sales = textdollar30 000 [1]
2
Application: (30 000)/(80 000) × 100 = 37.5% [1]

11. Profit margin

Profit margin is profit as a percentage of revenue. It shows how much of every dollar of sales is left after all costs.

Profit is gross profit minus expenses. Always divide by revenue, and give the answer as a percentage.

A business can earn more profit and still have a lower profit margin, if its costs have grown faster than its revenue.

profit = gross profit - expenses

profit margin = profit/revenue × 100%

Examiner insight

“A common mistake was to use the value for gross profit or revenue instead of profit.” “However, there were some issues where the GPM and NPM were written as fractions or as 0.25 and not as a percentage.”

Worked example 14 marks

Kiran Kites sells kites online. Last year its revenue was textdollar120 000, its cost of sales was textdollar72 000 and its expenses were textdollar36 000. Calculate Kiran Kites' profit margin. Show your working.

1
Knowledge: gross profit = revenue − cost of sales = textdollar48 000 [1]
2
Application: profit = gross profit − expenses = textdollar12 000 [1]
3
Application: profit margin = (12 000)/(120 000) × 100 = 10% [2]

12. Explaining a change in a margin

A margin changes when revenue, cost of sales and expenses change at different rates. If cost of sales rises faster than revenue, the gross profit margin falls. If expenses rise faster than revenue, the profit margin falls even when the gross profit margin holds. If revenue and costs rise in the same proportion, the margin stays the same.

Then say what the change means: less profit from each dollar of sales, so less to reinvest or to pay as dividends.

Examiner insight

“Better answers did recognise that the cost of sales could have increased due to the additional raw material needed as there were more sales (indicated by the higher sales revenue), but then did not see the significance of cost of sales increasing at a faster rate than revenue, hence the fall in the gross profit margin.” “However, the increase in expenses in the same ratio as the increase in revenue kept the profit margins the same was often overlooked.”

Worked example 16 marks

Green Bean Cafe sells coffee in a busy city centre. Its owner is worried because its profit margin fell between 2024 and 2025. Explain why the profit margin fell. Recommend one action the owner should take. Justify your answer.

	Revenue	Cost of sales	Expenses
2024	textdollar200 000	textdollar100 000	textdollar60 000
2025	textdollar250 000	textdollar160 000	textdollar60 000

1
Knowledge: profit margin = profit ÷ revenue × 100 [1]
2
Application: profit fell from textdollar40 000 to textdollar30 000, so the margin fell from 20% to 12% [1]
3
Analysis: cost of sales rose by 60%, much faster than revenue, which rose by 25% [1]
4
Analysis: so the gross profit margin fell from 50% to 36% [1]
5
Application: expenses did not change, so they did not cause the fall [1]
6
Evaluation: the cafe should look for cheaper coffee beans or raise its prices, as the cost of sales is the cause [1]

13. Return on capital employed (ROCE)

Return on capital employed (ROCE) is profit as a percentage of capital employed. It shows how much profit the business earns from the money invested in it.

Capital employed is total equity plus non-current liabilities: the long-term money in the business.

ROCE is a measure of efficiency, not of the level of profit. A higher ROCE means the business uses its capital better. Compare it with last year's ROCE or with a competitor's.

capital employed = total equity + non-current liabilities

ROCE = profit/(capital employed) × 100%

Examiner insight

“It was clear that a number of candidates did not understand that ROCE was a measure of efficiency and therefore produced answers that simply focused on the level of profits.” “Incorrect answers often focused on defining other financial terms such as dividends or profit margin.”

Worked example 14 marks

Nadia's Nuts roasts and sells nuts to cafes. Last year its profit was textdollar18 000 and its capital employed was textdollar120 000. Calculate Nadia's Nuts' ROCE and explain what it shows.

1
Knowledge: ROCE = profit ÷ capital employed × 100 [1]
2
Application: (18 000)/(120 000) × 100 = 15% [1]
3
Analysis: every textdollar100 of capital employed earned textdollar15 of profit, so ROCE shows how efficiently Nadia's Nuts uses its capital [1]
4
Analysis: on its own 15% cannot be judged, so compare it with last year's ROCE or with a competitor's [1]

14. Current ratio

Liquidity is how quickly a business can turn assets into cash to pay its short-term debts. The current ratio is a liquidity ratio. It compares current assets with current liabilities.

Write the answer as a ratio, such as 0.75 : 1, not as a sum of money. Below 1 : 1, current liabilities exceed current assets.

Use current assets and current liabilities only. Non-current assets and long-term loans are not part of it.

current ratio = current assets : current liabilities

Examiner insight

“However, one error was to write the ratios as a monetary value and another error was to express the ratio as total assets and liabilities rather than current assets and liabilities.” “Some candidates incorrectly calculated working capital rather than the current ratio.”

Worked example 12 marks

BTV’s 16 factories use flow production to manufacture cars. Maintaining quality is important. The managing director is reviewing BTV’s financial data including profit. An extract is in Table 3.1. Calculate BTV’s current ratio. Show your working.

Extract from BTV’s financial data - December 2025 ($ million)
non-current assets	700
current assets	90
current liabilities	120
non-current liabilities	300
profit	900

1
Knowledge: current ratio = current assets : current liabilities [1]
2
Application: 90 : 120 = 0.75 : 1 [1]

15. Acid test ratio

The acid test ratio is a stricter test of liquidity. It leaves out inventories, because they must be sold before they become cash.

It compares liquid assets with current liabilities. At 1 : 1 the business can just pay its short-term debts without selling inventories.

A business with a healthy current ratio can still have a weak acid test ratio, if most of its current assets are inventories.

acid test ratio = (current assets - inventories) : current liabilities

Examiner insight

“A common mistake was to calculate current ratio.” “Accurate labelling of each liquidity ratio was not always apparent.”

Worked example 14 marks

Mirza Motors sells used cars. Its current assets are textdollar60 000, of which textdollar40 000 is inventories. Its current liabilities are textdollar25 000. Calculate Mirza Motors' acid test ratio and comment on the result.

1
Knowledge: acid test ratio = (current assets − inventories) : current liabilities [1]
2
Application: (60 000 - 40 000) : 25 000 = 20 000 : 25 000 = 0.8 : 1 [1]
3
Analysis: it has only textdollar0.80 of liquid assets for every textdollar1 owed, so it cannot pay all its short-term debts without selling cars [1]
4
Evaluation: its current ratio of 2.4 : 1 looks healthy but hides this, so the acid test ratio gives the truer picture [1]

16. Interpreting liquidity ratios

Do not stop at the calculation. Say whether a ratio has risen or fallen, then what that means: can the business pay its short-term debts?

When the two ratios move in opposite directions, explain both. A rising current ratio with a falling acid test ratio usually means inventories have grown.

Apply the result to the business: its stock, its loan or its plans to expand.

Examiner insight

“Any supported judgement usually focused on the fact that while the current ratio had improved, the acid test ratio had decreased and this meant the business had fewer liquid assets to pay its debts immediately.” “Answers were mostly generic about liquidity and not applied to the business in the case study.”

Worked example 16 marks

Hamza's Hardware sells tools in three shops and plans to ask a bank for a loan. Its inventories grew during 2025. Assess whether its liquidity improved between 2024 and 2025.

	Current ratio	Acid test ratio
2024	1.6 : 1	0.9 : 1
2025	2.0 : 1	0.5 : 1

1
Knowledge: liquidity is the ability to pay short-term debts [1]
2
Application: the current ratio rose from 1.6 : 1 to 2.0 : 1, but the acid test ratio fell from 0.9 : 1 to 0.5 : 1 [1]
3
Analysis: the extra current assets are inventories of tools, which have to be sold before they become cash [1]
4
Analysis: an acid test ratio of 0.5 : 1 means only textdollar0.50 of liquid assets for each textdollar1 of short-term debts [1]
5
Evaluation: liquidity has weakened, whatever the current ratio says [1]
6
Evaluation: the bank may refuse the loan until Hamza's sells some of its tools stock or shows a cash-flow forecast [1]

17. Using ratios to make a decision

Profitability ratios (gross profit margin, profit margin and ROCE) show how well a business makes a profit. Liquidity ratios (current and acid test) show whether it can pay its debts. A business needs both.

Compare the ratios with last year's or with a competitor's. Then recommend. A justified decision says which ratio matters most and why, and what else is worth checking.

Link the decision to the business: a bank loan, paying dividends or expansion.

Examiner insight

“They did not understand the difference between profit and profitability.” “In the recommendation candidates still struggled to justify whether profitability or liquidity would have the most effect on AD’s objective of expansion.”

Worked example 18 marks

Dolma's Dairy makes cheese and wants a bank loan to build a second dairy. The bank manager compares ratios for two years. Should the bank manager lend to Dolma's Dairy? Justify your answer.

	Profit margin	ROCE	Current ratio
2024	12%	15%	1.8 : 1
2025	10%	9%	1.1 : 1

1
Knowledge: profitability ratios show how well profit is made, and the current ratio shows the ability to pay short-term debts [1]
2
Application: profit margin fell from 12% to 10% and ROCE from 15% to 9% [1]
3
Application: the current ratio fell from 1.8 : 1 to 1.1 : 1 [1]
4
Analysis: a lower ROCE means Dolma's Dairy earns less from its capital, so it uses it less efficiently [1]
5
Analysis: less profit from each dollar of sales leaves less money to repay a loan [1]
6
Analysis: at 1.1 : 1 there is little spare liquidity, and loan repayments would be a further cash outflow [1]
7
Evaluation: the bank manager should not lend now, as both profitability and liquidity have worsened [1]
8
Evaluation: liquidity is the larger risk to the bank, since loan repayments must be paid in cash; the manager should also check a cash-flow forecast [1]

Recap

Gross profit margin = gross profit ÷ revenue × 100.
Profit margin = profit ÷ revenue × 100. Profit is gross profit minus expenses.
A margin falls when costs rise faster than revenue, even if profit rises.
ROCE = profit ÷ capital employed × 100. It measures efficiency.
Current ratio = current assets : current liabilities. It measures liquidity.
Acid test ratio = (current assets − inventories) : current liabilities.
Explain what a ratio shows for this business. Then make a justified decision.

18. Who uses accounts

A business's accounts are read by more than its owners. External users of accounts include customers, lenders / banks, suppliers, the local community, the government, potential investors / shareholders / owners and competitors.

A bank wants to see if a loan is likely to be repaid, a supplier that it will be paid, a shareholder the return on the investment, and employees whether to ask for a pay rise. Name the users of the accounts, not stakeholders in general.

Examiner insight

“However, weaker responses were related to stakeholders in general, rather than those concerned with the accounts.” “A common mistake was to confuse suppliers with customers as the first stakeholder group.”

Worked example 12 marks

The managing director is reviewing BTV's financial data including profit. She knows there are many external users of accounts who are interested in this data. Identify two external users of accounts.

1
Knowledge: one external user, for example lenders / banks [1]
2
Knowledge: a second, different external user, for example suppliers or the government [1]

19. Lenders deciding whether to lend

A bank reads a business's accounts to judge its ability to repay the loan. It looks at the profit made, the loans already outstanding and the liquidity ratios.

Liquidity matters because it shows whether short-term debts can be repaid. A weak result may lead the bank to refuse the loan. Say which figure the bank uses and how it changes the decision.

Examiner insight

“Stronger responses were able to explain which piece of financial information would be useful and how it affected the decisions made by the stakeholder.” “The best developed answer for a stakeholder group was for CC’s bank manager to see if the amount of loans already outstanding, profit made, and liquidity ratios were useful to assess the ability of the business to repay the loan and whether CC should be granted the loan.”

Worked example 14 marks

Mehta Printing asks Lakeside Bank for a textdollar50 000 loan to buy a new press. Its accounts show a profit of textdollar18 000 last year and a current ratio of 0.8 : 1. Explain how Lakeside Bank might use the accounts to decide whether to lend.

1
Knowledge: the bank uses the accounts to judge whether the loan can be repaid [1]
2
Application: the textdollar50 000 loan is almost three years of the textdollar18 000 profit [1]
3
Analysis: current assets are below current liabilities, so short-term debts may go unpaid [1]
4
Analysis: the bank may therefore refuse the loan or lend less [1]

20. Investors deciding whether to invest

A shareholder or potential investor reads the accounts to judge the return on investment. Profit shows whether a dividend can be paid.

The same figures decide whether to sell or buy more shares. Falling profit makes a business less likely to pay increased dividends, so it is less worth investing in.

Compare the figures and say what the change means for the investor.

Examiner insight

“Weaker answers just considered what was happening to the figures, e.g. for example revenue increased by $50m or incorrectly calculated the ratios.” “Few candidates applied their answers to the business in the case and therefore few candidates gained full marks.”

Worked example 14 marks

Nadia is thinking of buying shares in Zoom Bikes plc. Its accounts show that profit fell from textdollar400 000 to textdollar300 000 and that the dividend was cut. Explain how Nadia might use the accounts to decide whether to invest.

1
Knowledge: an investor uses the accounts to judge the return on the investment, such as dividends [1]
2
Application: profit fell from textdollar400 000 to textdollar300 000 and the dividend was cut [1]
3
Analysis: less profit leaves less to pay dividends, so Nadia's return would be lower [1]
4
Analysis: she may decide not to buy the shares, or a current shareholder may sell [1]

21. Reading ratio results

Ratio analysis turns the figures in the accounts into results that can be compared. A liquidity ratio shows whether a business can pay its short-term debts.

A current ratio below 1 : 1 means current assets are less than current liabilities. A user must label the ratio, say what the result shows and link it to the decision.

current ratio = current assets : current liabilities

Examiner insight

“Accurate labelling of each liquidity ratio was not always apparent.” “Weaker responses were characterised by simple statements such as the acid test ratio had decreased but did not show any analysis or use the data to support points made.”

Worked example 12 marks

The managing director is reviewing BTV's financial data including profit. Calculate BTV's current ratio. Show your working.

Extract from BTV's financial data, December 2025	textdollar million
non-current assets	700
current assets	90
current liabilities	120
non-current liabilities	300
profit	900

1
Knowledge: current ratio = current assets : current liabilities [1]
2
Application: 90 : 120 = 0.75 : 1 [1]

22. Using the evidence to reach a decision

A good answer uses the figures for each user, then makes a justified decision. It weighs the evidence for and against, and it makes reference to this business.

A simple piece of advice, with no reasoned argument from the figures, is a weak recommendation.

Examiner insight

“Better recommendations did more than offer a simple piece of advice to Philip’s sister whether to invest or not in PF.” “The best answers justified their decision with reasoned argument, supported by financial analysis, about which would be the wisest course of action.”

Worked example 18 marks

Greenleaf Foods is a bakery with 40 employees. It asks Harbour Bank for a textdollar60 000 loan to buy a second oven. Its profit rose from textdollar20 000 to textdollar35 000, but its current ratio fell from 1.5 : 1 to 0.9 : 1. Advise whether Harbour Bank should lend the money.

1
Knowledge: the bank uses profit and liquidity ratios to judge if the loan can be repaid [1]
2
Application: profit rose from textdollar20 000 to textdollar35 000 [1]
3
Analysis: rising profit suggests Greenleaf can make repayments from future earnings [1]
4
Application: the current ratio fell from 1.5 : 1 to 0.9 : 1, below 1 : 1 [1]
5
Analysis: current assets are below current liabilities, so short-term debts may go unpaid [1]
6
Evaluation: a decision, for example lend [1]
7
Evaluation: justified, because rising profit shows the bakery is growing [1]
8
Evaluation: weighed against the weak liquidity, which the bank should check first [1]

Recap

External users of accounts: customers, lenders / banks, suppliers, local community, government, potential investors / shareholders / owners, competitors.
Each user reads the accounts for a different reason: lenders to see if a loan is repaid, suppliers to see if they are paid, shareholders to see the return, employees to see if they should ask for a pay rise.
Banks look at profit, loans already outstanding and liquidity ratios to judge if the business can repay.
Investors use profit and dividends to decide whether to buy or sell shares.
Current ratio = current assets : current liabilities. Below 1 : 1 means current assets are less than current liabilities.
Use the business's own figures, say what they mean, then give a justified decision.

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

Tamsin's Tea Room made a profit of textdollar20 000 last year. Tamsin's accountant tells her to look at the profitability of the business as well. Define 'profitability'.2 marks
Nadia owns a nail studio. Identify two reasons why profit is important to her.2 marks
Last year Bao's Bikes made a profit of textdollar20 000 on revenue of textdollar100 000. This year it made a profit of textdollar24 000 on revenue of textdollar160 000. State whether its profit and its profit margin rose or fell. Show your working.2 marks
Lena owns a pizza restaurant with six waiters. She put textdollar40 000 of her own savings into it. Last year it made a profit of textdollar25 000. Outline two ways Lena could use this profit.4 marks
Tariq's Taxis wants a bank loan of textdollar40 000 to buy two electric cars. Last year 10% of its revenue was profit. This year the figure is 6%. Outline two reasons why the bank will look at the profitability of Tariq's Taxis.4 marks
Solar Sam Ltd makes solar chargers. It plans to build a second factory and is looking for new shareholders. Explain two reasons why profit is important to Solar Sam Ltd.6 marks
Orla owns Organic Orla, a farm shop with ten employees. She started it with her own savings. Explain two ways Orla could use this year's profit. Which is likely to be the more important? Justify your answer.6 marks
Pat runs Pat's Pots, which makes garden pots. Pat says: 'Profit is up, so the business is more successful.' Do you agree? Justify your answer. | | Revenue | Profit | | --- | --- | --- | | Year 1 | textdollar50 000 | textdollar10 000 | | Year 2 | textdollar75 000 | textdollar15 000 |6 marks
Dune Riders Ltd runs quad-bike tours in the desert. It has three shareholders and still owes its bank textdollar150 000. The managing director says: 'Profit is up, so nobody needs to worry.' Explain two reasons why the change in the profitability of Dune Riders Ltd matters. | | Revenue | Total costs | | --- | --- | --- | | Year 1 | textdollar400 000 | textdollar320 000 | | Year 2 | textdollar600 000 | textdollar510 000 |8 marks
Imran has textdollar200 000 to invest and wants regular dividends. He can buy shares in one of two ferry companies. Harbour Hop Ltd has been running for twelve years. Island Link Ltd opened two years ago. Which company should Imran choose? Justify your answer. | | Revenue | Total costs | | --- | --- | --- | | Harbour Hop, last year | textdollar800 000 | textdollar680 000 | | Harbour Hop, this year | textdollar1 000 000 | textdollar870 000 | | Island Link, last year | textdollar200 000 | textdollar170 000 | | Island Link, this year | textdollar300 000 | textdollar240 000 |12 marks
Amara's accountant says that her bakery, Amara Bakes, has poor liquidity. Define 'liquidity'.2 marks
Pedro runs a taxi firm with six cars. Identify two reasons why liquidity is important to Pedro's firm.2 marks
Kiln Pottery has non-current assets of textdollar80 000, current assets of textdollar45 000, current liabilities of textdollar30 000 and non-current liabilities of textdollar20 000. Calculate its current ratio. Show your working.2 marks
Fern Florist made a profit of textdollar18 000 last year. It has textdollar600 in cash and owes its flower supplier textdollar4 000, due in 7 days. The owner says, 'We are profitable, so we cannot have a liquidity problem.' Explain why she is wrong.4 marks
Harbour Tea is a market stall. It buys its tea from one supplier and must pay within 14 days. Explain one reason why liquidity is important to Harbour Tea.4 marks
Sol's Print Shop has textdollar1 000 in cash and a loan repayment of textdollar12 000 due next month. It owns one large printing machine. Explain one consequence of its low liquidity.4 marks
Tula Toys is a new shop. It has textdollar2 000 in cash and must pay textdollar8 000 for a delivery of toys in 14 days. The owner wants a bank loan to open a second shop. Explain two problems that low liquidity may cause Tula Toys.6 marks
Hale Hardware sells tools. Its current ratio fell from 1.2 : 1 last year to 0.8 : 1 this year. The owner plans to ask a bank for a loan. Do you think the fall should worry the owner? Justify your answer.6 marks
Sami owns Island Hopper, which runs two passenger ferries. The table gives figures from its accounts. Sami says, 'Profit is up, so our liquidity has improved.' Is Sami right? Justify your answer using the data. | ($ thousand) | Year 1 | Year 2 | | --- | --- | --- | | profit | 40 | 55 | | non-current assets | 300 | 360 | | current assets | 60 | 54 | | current liabilities | 40 | 72 |8 marks
Altitude Surveys uses drones to map farmland. It employs two drone pilots. It has textdollar18 000 in cash, and wages and insurance of textdollar12 000 to pay within 30 days. Customers owe it textdollar6 000, due in 30 days. A farming group offers a contract worth textdollar40 000, to be paid 90 days after the work is finished. To do the work, the owner, Tariq, must spend textdollar15 000 of the cash on a new drone now. Do you think Tariq should accept the contract? Justify your answer.12 marks
Jamal runs a bakery. State what is meant by gross profit margin.2 marks
Do Bakers sells cakes. Its revenue is textdollar50 000, its cost of sales is textdollar30 000 and its expenses are textdollar5 000. Calculate its profit margin.2 marks
Hira's Handbags has current assets of textdollar45 000 and current liabilities of textdollar30 000. Calculate its current ratio.2 marks
Omar's Office Supplies has current assets of textdollar84 000, of which textdollar48 000 is inventories. Its current liabilities are textdollar36 000. Calculate its acid test ratio.2 marks
Studio Lumi sells candles. Last year its revenue was textdollar60 000 and its cost of sales was textdollar36 000. This year its revenue was textdollar80 000 and its cost of sales was textdollar52 000. Calculate its gross profit margin for each year and state whether it improved.4 marks
Ayaan owns a printing firm. Last year its profit was textdollar27 000. Its total equity was textdollar150 000 and its non-current liabilities were textdollar60 000. Calculate its ROCE. Give your answer to one decimal place.4 marks
Faiza's Fashion sells dresses. Its revenue rose from textdollar100 000 to textdollar150 000 and its profit rose from textdollar20 000 to textdollar24 000. Explain whether its profit margin improved.4 marks
Zed Wheels sells tyres. Calculate its current ratio and its acid test ratio for each year. Comment on its liquidity. | | Current assets | Inventories | Current liabilities | | --- | --- | --- | --- | | 2024 | textdollar120 000 | textdollar70 000 | textdollar60 000 | | 2025 | textdollar150 000 | textdollar110 000 | textdollar75 000 |6 marks
Mei wants to buy shares in one of two bicycle makers, Pedal Works and Spoke and Co. She wants the best return on the money she invests. Calculate the gross profit margin, the profit margin and the ROCE of each business. Which business should Mei choose? Justify your answer. | | Revenue | Cost of sales | Expenses | Total equity | Non-current liabilities | | --- | --- | --- | --- | --- | --- | | Pedal Works | textdollar500 000 | textdollar300 000 | textdollar150 000 | textdollar200 000 | textdollar50 000 | | Spoke and Co | textdollar800 000 | textdollar400 000 | textdollar320 000 | textdollar500 000 | textdollar300 000 |8 marks
Rosa's Roastery roasts coffee beans and sells them to cafes. Rosa wants a bank loan of textdollar60 000 to open a second roastery. She tells the bank manager that her profit and her current ratio both rose in 2025. Calculate the profitability ratios and liquidity ratios the bank manager would use. Should the bank lend? Justify your decision. | | Revenue | Cost of sales | Expenses | Current assets | Inventories | Current liabilities | Capital employed | | --- | --- | --- | --- | --- | --- | --- | --- | | 2024 | textdollar300 000 | textdollar150 000 | textdollar90 000 | textdollar80 000 | textdollar30 000 | textdollar50 000 | textdollar400 000 | | 2025 | textdollar400 000 | textdollar220 000 | textdollar108 000 | textdollar135 000 | textdollar90 000 | textdollar75 000 | textdollar600 000 |12 marks
Delta Ltd makes bicycle frames. State two external users of Delta's accounts.2 marks
Orchid Shop has current assets of textdollar54 000 and current liabilities of textdollar45 000. Calculate its current ratio. Show your working.2 marks
Rosa's Bakery buys flour from a supplier. The bakery's accounts show current assets of textdollar38 000 and current liabilities of textdollar52 000. Explain one way the supplier might use the accounts.2 marks
Jamal Tailors made a profit of textdollar24 000 last year and textdollar31 000 this year. Explain how Jamal's employees might use the accounts.4 marks
Kestrel Cycles asks Eastern Bank for a textdollar20 000 loan. Its profit was textdollar9 000 and its current ratio is 1.2 : 1. Explain how Eastern Bank might use the accounts to decide whether to lend.4 marks
Tidewater plc's profit fell from textdollar2.0 million to textdollar1.4 million and it paid a lower dividend. Explain how a shareholder might use the accounts to decide whether to sell shares.4 marks
Brightway Ltd makes school bags. Its profit was textdollar45 000 and its current ratio was 0.9 : 1. Explain how (i) a supplier and (ii) a bank might each use Brightway's accounts.6 marks
Pier Café's current ratio fell from 1.6 : 1 to 0.8 : 1. Pier Café has asked Quay Bank for a loan. Should Quay Bank lend? Justify your answer.6 marks
Selim has been invited to buy shares in Corva Ltd, which makes garden furniture. All figures are in textdollar000. In 2025 Corva had current assets of 240, current liabilities of 150 and a profit of 90. The forecast for 2026 is current assets of 270, current liabilities of 300 and a profit of 120. Advise Selim whether to invest in Corva. Justify your answer.8 marks
Maple Toys Ltd makes wooden toys. It asks Northgate Bank for a textdollar200 000 loan to open a second factory. Its accounts, with all figures in textdollar000, show profit of 110 two years ago and 80 last year, current assets of 168, current liabilities of 80 and loans already outstanding of 150. Advise whether Northgate Bank should lend the money. Justify your answer.12 marks

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Business activity Classification of businesses Enterprise, business growth and size Types of business organisation Business objectives and stakeholder objectives Motivating employees

Read the notes

1. Profit and profitability#

2. Profit as a source of funds#

3. Profit as a measure of success and a reward#

4. Why profitability matters#

5. What liquidity means#

6. Liquidity is not profit or cash flow#

7. Why liquidity matters#

8. Low liquidity and lenders#

9. Judging liquidity: the current ratio#

10. Gross profit margin#

11. Profit margin#

12. Explaining a change in a margin#

13. Return on capital employed (ROCE)#

14. Current ratio#

15. Acid test ratio#

16. Interpreting liquidity ratios#

17. Using ratios to make a decision#

18. Who uses accounts#

19. Lenders deciding whether to lend#

20. Investors deciding whether to invest#

21. Reading ratio results#

22. Using the evidence to reach a decision#

End-of-chapter exercise

Go deeper

Workbook

Chapter at a Glance

Free notes are just the start.

Related chapters

1. Profit and profitability

2. Profit as a source of funds

3. Profit as a measure of success and a reward

4. Why profitability matters

5. What liquidity means

6. Liquidity is not profit or cash flow

7. Why liquidity matters

8. Low liquidity and lenders

9. Judging liquidity: the current ratio

10. Gross profit margin

11. Profit margin

12. Explaining a change in a margin

13. Return on capital employed (ROCE)

14. Current ratio

15. Acid test ratio

16. Interpreting liquidity ratios

17. Using ratios to make a decision

18. Who uses accounts

19. Lenders deciding whether to lend

20. Investors deciding whether to invest

21. Reading ratio results

22. Using the evidence to reach a decision