Evaluate ratios and recommend performance improvements
Combine ratio trends with comparisons and business evidence, then recommend actions while explaining accounting-information limits.
Exam scope and assessment notes
Cambridge International AS & A Level Accounting 9706, 2026–2028 syllabus, Version 2. These original lessons cover objectives 1.6.1–1.6.2: stakeholder information needs, communication, the listed profitability, liquidity and efficiency ratios, interpretation, improvement measures and limitations. Ratio formulae follow the official syllabus appendix; use its formulae in candidate responses. Practice is self-checked, not an official Cambridge grade; timed Papers 1–4 and human subject-teacher review remain outstanding.
Before you begin
- Use the Topic 1.5 statements and distinguish revenue, gross profit, operating profit, profit for the year, assets, liabilities and equity before selecting a ratio.
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
A ratio is better than last year. What is the safest immediate conclusion?
What you will learn
- Evaluate profitability, liquidity and efficiency together
- Recommend measures with relevant benefits, risks and evidence
- Explain limitations of accounting information
Build an evidence-based comparison
Compare a business with its own earlier periods, a similar business or an industry benchmark only when the basis is sufficiently comparable. State the period, formula, direction of change and what it may suggest. Use several related measures: for example, gross profit margin with mark-up, profit margin and sales volume; current ratio with acid test and inventory days.
Ratios show relationships, not causes. Link a proposed explanation to supporting statements, notes, budgets, operational records or non-financial evidence. Distinguish a fact from an inference and identify information still needed before a firm recommendation.
Choose improvement measures with trade-offs
Profitability may improve through appropriate pricing, product mix, purchasing or cost control, but price rises can reduce volume and indiscriminate cuts can harm quality. Liquidity may improve through cash planning, faster collection and careful inventory management, but aggressive credit limits or late supplier payments can damage sales and relationships.
Efficiency may improve when capacity is used productively, receivables are collected promptly, suppliers are managed and inventory is aligned to demand. Check service quality, stock availability, employee effects and supplier terms. A ratio target should not replace the company’s actual purpose and constraints.
Recognize limits in the accounting evidence
Financial statements are historical, monetary summaries and may rely on estimates and accounting-policy choices. Businesses may differ in size, product mix, asset age, reporting dates, policies and market conditions; one-off events, seasonality, inflation and window dressing can distort a comparison.
Accounts do not capture every non-financial factor, future uncertainty, product quality, staff morale or environmental impact. Use ratios as evidence for a decision, not as a guarantee or a stand-alone rating. State which limitation matters in the scenario and what further evidence would reduce it.
Pause and explain
Which is a limitation of using published accounting statements alone?
Worked example
A retailer’s profit margin rises from 8% to 10%, current ratio from 1.2:1 to 1.8:1, and inventory days from 45 to 85. Evaluate whether overall performance clearly improved and recommend one next investigation.
Show the worked solution
- The higher profit margin may indicate a stronger profit return per dollar of revenue, but check sales volume, one-off items and cost changes.
- The current ratio rises, yet inventory is held longer; extra stock may explain some of the apparent liquidity increase.
- Check the acid test, inventory age and condition, sales forecasts and supplier terms before deciding whether to reduce stock or change credit policy.
Answer The evidence is mixed. Profit margin improved, but the current-ratio rise may be tied to slower inventory and does not prove stronger cash availability. Review the acid test, inventory ageing and sales forecasts before recommending a stock or credit change.
Try a topic test
Choose Easy, Normal or Difficult. Save your answers and open worked review after finishing.
Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
A manufacturer’s ROCE rises from 12% to 16% after an old machine is fully depreciated. State one possible interpretation and two checks before calling operations more efficient.
Give me a hint
The denominator may have changed even if operating profit did not improve.
Compare my reasoning
- A lower net book value can raise ROCE by reducing capital employed.
- Check profit from operations and asset age/capacity use.
- Compare replacement investment, production volume, quality and other relevant efficiency ratios before concluding output improved.
ROCE may have risen because the depreciated machine reduced the capital-employed denominator. Check operating profit, asset age and capacity, output and other efficiency evidence before concluding that operational efficiency improved.
Look for these in your work
- Denominator effect identified
- Profit and asset evidence checked
- Operational conclusion qualified
A firm’s gross profit margin falls, but profit margin rises after it cuts administrative staff. Explain how both movements can occur and identify a non-financial effect to investigate.
Give me a hint
Gross profit margin is above operating expenses; profit margin is after the period’s expenses and interest basis.
Compare my reasoning
- Higher purchase costs or lower selling prices can reduce gross profit margin.
- Lower administrative expenses may increase profit for the year relative to revenue enough to raise profit margin.
- Investigate workload, service quality, errors or staff retention to assess whether the staffing cut has a material non-financial cost.
The gross margin may fall because of pricing, product mix or cost of sales, while lower administrative costs improve the final profit margin. Check service quality, workload and staff retention before treating the cost cut as sustainable.
Look for these in your work
- Gross-margin driver separated
- Expense effect explained
- Non-financial consequence identified
A board proposes cutting all staff training to improve this year’s operating-expenses ratio. Make a balanced recommendation and state what evidence to monitor.
Give me a hint
Consider the short-term expense effect and possible effect on errors, service and future capability.
Compare my reasoning
- Training cuts may reduce current operating expenses and lower the ratio in the short term.
- They may increase mistakes, turnover, safety or service problems, harming future revenue and costs.
- Pilot targeted changes and monitor training spend, quality errors, customer satisfaction, output, staff turnover and operating margin over time.
Do not cut all training solely to improve a ratio. Identify low-value spending, preserve essential capability and test targeted changes. Monitor service quality, errors, staff retention, output and operating margin over time; explain that the ratio does not capture all consequences.
Look for these in your work
- Short-term ratio effect considered
- Long-term trade-off identified
- Relevant monitoring proposed
Common mistakes
- Declaring a business healthy because one ratio improved
- Comparing businesses without checking their activities, policies or reporting periods
- Recommending a ratio improvement without considering customers, employees or suppliers
What can you explain now?
Why should a ratio comparison be checked for consistency of formula and accounting period?
Compare with the explanation
A difference may reflect the calculation basis or timing rather than a real performance change
A valid comparison needs a sufficiently comparable measure and reporting period.
After trying it yourself, choose your next review. This is your self-assessment.
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Make it stick
Give four limitations of accounting information and one way to strengthen a ratio-based recommendation.
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.