The starting point for ratios is, of course, technical knowledge , which will mean you can calculate any ratio’s asked for accurately, make an assessment on what a good result is and work out what this means should it increase or decrease, year on year. This however, is probably the easiest aspect of ratio questions. Explaining or applying these ratios correctly is where we find that our students struggle the most, at all levels of exams. It’s common to develop tunnel vision. Looking at ratios purely through the eyes of an accountancy student and not from a wider perspective is where problems start to arise. When tackling these questions, you need to use your business acumen skills and draw on what you know as an employee, member of society or whichever perspective you asked to consider the company from in the exam question.
If you’re asked to assess the profitability of a company in a more open-ended question, using ratios will definitely enhance your analysis. However, take the time to step back and ask yourself a few questions before frantically committing every ratio you know to paper. These questions might include:
- Is the company profitable?
- Has it made more profit than last year?
- Have we got any information in the question that will help us make comparisons? (e.g. previous years, reference to other companies or industry standards)
- If so, is the company more or less profitable than the comparison information?
- Are there any indications in the question as to why this might have happened?
- Can you speculate, sensibly on why sales have increased? For example, as a result of a marketing campaign.
- What is driving the difference between gross profit margin and net profit margin?
- We know that the above is related to the expenses within the company but is there enough information in the question to help us make conclusions?
If you ask yourself these types of questions, it can help you to identify the relevant sections of the accounts to discuss and relevant ratios to calculate. Note the key word here; relevant. The person marking your exam paper is not looking for you to show that you know every ratio you’ve been taught. They’re looking for you to use the ones that are relevant to the question. You’ll often be provided with some ratios and this is a good starting point in determining what comparators to calculate.
Equally, it’s important to consider the terminology you use. As Tutors, we can often read between the lines to decipher what a student means but at the same time we may be cautious to award marks as it’s not clear that they’ve fully understood the concepts. As an example, if we look at the current ratio, which looks at the relationship between current assets and liabilities, students will often write that the ratio has improved, as the current assets have increased. Now to demonstrate your accounting understanding, explain what makes up the current assets balance and what specifically has increased. Some students will explain this as the company being better equipped to pay their bills, but the ratio actually looks at the ability to cover liabilities. It doesn’t specifically cover your ability to pay future invoices.
To summarise, ratios should not be scary. We analyse businesses all the time, whether watching the news, reading articles at work or working through exam questions. Ratios are a key tool to enhance your analysis but don’t forget that you need to draw conclusions and include context in your answer. This is the way to successfully tackle ratios in exams rather than giving the person marking the paper, a list of every ratio you know.