EnglandBusinessSyllabus dot point

How do financial ratios reveal the health of a business?

The purpose of ratio analysis, the calculation and interpretation of liquidity (current ratio), profitability (ROCE), gearing and efficiency ratios, and the value and limitations of ratio analysis.

A focused answer to AQA A-Level Business 3.5, covering the purpose of ratio analysis, the calculation and interpretation of liquidity, profitability, gearing and efficiency ratios, and the value and limitations of ratio analysis for judging performance.

Generated by Claude Opus 4.811 min answerUpdated 2026-06-02

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The purpose of ratio analysis
Liquidity: the current ratio
Profitability: ROCE
Gearing and efficiency
Value and limitations

What this dot point is asking

AQA wants you to explain the purpose of ratio analysis, calculate and interpret the key ratios (current ratio, ROCE, gearing and efficiency ratios), and evaluate the value and limits of the technique. Paper 2 typically provides a small set of balance sheet and income statement figures and asks for two or three ratios plus an assessment; the calculations are simple division, and the marks live in the interpretation against a benchmark.

The purpose of ratio analysis

Liquidity: the current ratio

The current ratio measures whether a firm can meet its short-term debts from its short-term assets:

\text{Current ratio} = \frac{\text{current assets}}{\text{current liabilities}}

A ratio around 1.5 to 2 is often seen as healthy. Below 1 means current liabilities exceed current assets, signalling possible liquidity stress, though fast-turnover retailers and supermarkets run comfortably below 1 because cash comes in before suppliers are paid. A ratio well above 2 to 3 can signal idle cash or excess stock that could be working harder.

Profitability: ROCE

Return on capital employed (ROCE) is the headline profitability ratio because it relates profit to all the long-term capital used to generate it:

\text{ROCE} = \frac{\text{operating profit}}{\text{capital employed}} \times 100

Capital employed is total equity plus non-current liabilities (the long-term funding). A higher ROCE means capital is used more profitably. The key benchmark is the cost of finance: a ROCE of 18 percent against borrowing at 7 percent shows the firm earns far more on its capital than it costs to raise, creating value. ROCE is not the profit margin: margin relates profit to sales, while ROCE relates profit to capital.

Gearing and efficiency

The gearing ratio shows how reliant the firm is on long-term debt:

\text{Gearing} = \frac{\text{non-current liabilities}}{\text{capital employed}} \times 100

Above 50 percent is conventionally high gearing: returns are amplified in good times but interest must be paid in bad times, raising insolvency risk. Capital-intensive firms run higher gearing routinely. Efficiency ratios such as inventory (stock) turnover and receivables or payables days show how well the firm manages stock and credit; faster stock turnover and quicker collection free up cash.

Working the key ratios

Step 1: current ratio (liquidity)

Current assets are $\pounds120{,}000$ and current liabilities $\pounds60{,}000$ . Current ratio $= \dfrac{120{,}000}{60{,}000} = 2$ , so the firm has $\pounds2$ of current assets for every $\pounds1$ of short-term debt: healthy liquidity.

Step 2: ROCE (profitability)

Operating profit is $\pounds80{,}000$ on capital employed of $\pounds400{,}000$ . ROCE $= \dfrac{80{,}000}{400{,}000} \times 100 = 20\%$ : each pound of capital earns 20 pence of operating profit, well above borrowing costs.

Step 3: gearing (solvency)

Non-current liabilities are $\pounds300{,}000$ and capital employed $\pounds600{,}000$ . Gearing $= \dfrac{300{,}000}{600{,}000} \times 100 = 50\%$ , which sits on the high-gearing threshold, so the firm relies heavily on debt and is exposed if profits fall.

Step 4: pull it together

Strong profitability and sound liquidity, but the high gearing is the watch-point. The firm earns good returns now, partly because debt finance amplifies them, so a downturn would amplify the downside too.

Value and limitations

Ratios summarise complex accounts into a few comparable figures and aid decision-making and benchmarking. But they are based on past data, ignore qualitative factors (staff quality, brand, market position, ESG), can be distorted by one-off events or by different accounting policies between firms, and mean nothing without a benchmark. The best answers always interpret a ratio against a trend, a rival or an industry norm.

Exam-style practice questions

Practice questions written in the style of AQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

AQA 20219 marksA retailer reports operating profit of

\pounds540{,}000

, capital employed of

\pounds3{,}000{,}000

, current assets of

\pounds480{,}000

, current liabilities of

\pounds300{,}000

and non-current liabilities of

\pounds1{,}200{,}000

. Calculate the ROCE, current ratio and gearing ratio, and assess the financial health of the business. (9 marks, Paper 2 quantitative section)

Show worked answer →

Show each formula and figure for the method marks, then assess.

\text{ROCE} = \frac{540{,}000}{3{,}000{,}000} \times 100 = 18\%

Current ratio $= \frac{480{,}000}{300{,}000} = 1.6$ .

\text{Gearing} = \frac{1{,}200{,}000}{3{,}000{,}000} \times 100 = 40\%

Assessment: ROCE of 18 percent is strong and comfortably beats typical borrowing costs, so capital is used profitably. A current ratio of 1.6 is healthy, with enough current assets to cover short-term debts (and low stockholding is normal for some retail models). Gearing of 40 percent is below the 50 percent high-gearing threshold, so reliance on debt is moderate and the firm is not over-borrowed. Overall the business looks financially healthy, though a one-period snapshot needs a trend or a rival benchmark to confirm. Markers reward three correct calculations and an assessment that judges each figure against a benchmark rather than just restating it.

AQA 20184 marksExplain one limitation of using ratio analysis to judge the performance of a business. (4 marks)

Show worked answer →

Pick one limitation and develop it with a consequence.

For example: ratios are based on past financial data. They report what has already happened (last year's balance sheet and income statement) and so may not reflect current trading or future prospects. A firm could show a strong current ratio at the year-end yet face a sharp downturn weeks later that the figures cannot capture, so a decision based purely on historic ratios can mislead. Other valid limitations: ratios ignore qualitative factors (brand, staff, market position), can be distorted by one-off events or different accounting policies, and mean little without a benchmark. Markers reward one limitation clearly explained with a practical consequence, applied where possible to the context, rather than a list of unexplained limitations.

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Sources & how we know this

AQA A-level Business (7132) specification — AQA (2015)