Analysing financial statements: ratio analysis
Ratio analysis uses figures from a business's financial statements to calculate ratios that make performance easier to compare, over time or against other businesses, than looking at raw pound figures alone.
Before you start
Make sure you're comfortable with these topics first:
Method
- Identify which figures the ratio needs from the income statement, e.g. gross profit and revenue for the gross profit margin.
- Apply the correct formula and calculate the ratio as a percentage.
- Compare the calculated ratio with a previous period, a target, or a competitor's figure, since a single ratio in isolation has limited meaning.
- State whether the ratio has improved or worsened, and by how many percentage points.
- Suggest a likely cause linked to the numbers, for example higher cost of sales lowering the gross margin, or lower overheads improving the net margin.
- For an evaluate-style question, weigh what the ratio suggests against its limitations, such as ratios not showing the reasons behind a change or not accounting for one-off events.
Worked example
A business's gross profit margin was 40% last year and its net profit margin was 15% last year. This year, its gross profit margin is 42% and its net profit margin is 16%. Calculate the change, in percentage points, in each ratio, and suggest what the pattern of change suggests about the business's cost control this year.
- Calculate the change in gross profit margin: 42% - 40% = 2 percentage points.
- Calculate the change in net profit margin: 16% - 15% = 1 percentage point.
- Compare the two changes: the gross margin improved by more (2 points) than the net margin (1 point).
- Interpret the pattern: the business improved its control of the cost of sales, raising the gross margin, by more than it improved control of its other expenses, since the net margin rose by less than the gross margin, suggesting other expenses grew slightly relative to revenue.
Practice questions
Try each question, then tap to reveal the answer.
Q1What does the gross profit margin measure?Show answer
Answer: Gross profit as a percentage of revenue, showing how much of each pound of sales is left after paying the direct cost of sales.
Q2What does the net profit margin measure?Show answer
Answer: Net profit as a percentage of revenue, showing how much of each pound of sales is left as profit after all costs, including expenses, are deducted.
Q3A business's gross profit margin falls from 35% to 30%. State whether this is an improvement or a decline.Show answer
Answer: A decline - a lower gross profit margin means less of each pound of sales is being kept as gross profit.
Q4Give one reason a business's net profit margin might fall even if its gross profit margin stays the same.Show answer
Answer: For example, its expenses, such as rent, wages or marketing, have risen relative to revenue, reducing net profit even though gross profit as a percentage of revenue is unchanged.
Q5Why is comparing a ratio to a previous year usually more useful than looking at the ratio for a single year alone?Show answer
Answer: Because a single ratio does not show whether performance is improving or worsening; comparing it over time, or with a competitor, shows the trend and gives the figure meaning.
Q6Name one limitation of using ratio analysis to judge business performance.Show answer
Answer: For example, ratios do not explain the reasons behind a change, or can be distorted by one-off events, or do not account for differences between businesses in different industries.
Q7A business's net profit margin rises from 8% to 11%. Calculate the change in percentage points.Show answer
Answer: 11% - 8% = 3 percentage points.
Exam-style questions
Written in the style of a GCSE Business exam paper, with a full mark scheme.
A business reports the following for two years. Year 1: revenue 200,000 pounds, gross profit 80,000 pounds, net profit 30,000 pounds. Year 2: revenue 240,000 pounds, gross profit 84,000 pounds, net profit 36,000 pounds. (a) Calculate the gross profit margin for Year 1 and Year 2. (2 marks) (b) Calculate the net profit margin for Year 1 and Year 2. (2 marks) (c) State whether the business's control of its expenses, other than cost of sales, improved or worsened between Year 1 and Year 2, using your figures from (a) and (b) to support your answer. (2 marks)
Show mark scheme
Tick each line you got. Your score builds from the marks on the scheme.
Nothing ticked yet - 6 available
Assess the value of ratio analysis, such as the gross profit margin and net profit margin, in helping a business owner judge how well their business is performing.
Show mark scheme
Tick each line you got. Your score builds from the marks on the scheme.
Nothing ticked yet - 6 available
See real GCSE Business past-paper questions, with official mark schemes →
Free printable worksheet
Want more practice on paper? Download the analysing financial statements: ratio analysis worksheet pack - 8 pages of exam-style questions with a full mark scheme. One email opens every download in this browser for 14 days - no account, no card. Print it for personal and classroom use.
Next topics
Not quite what you needed?
Tell us what is missing on analysing financial statements: ratio analysis, or which topic to write up next. Every request is read, and we reply to every one.
Build a full practice pack.
This topic is one of hundreds in the library - pick the ones a student needs and generate a printable PDF in minutes.