What you'll learn
- Why we calculate and compare financial ratios
- The profitability ratios: gross profit margin, net profit margin and return on equity
- The liquidity ratios: current ratio and acid-test ratio
- The solvency ratio: debt-equity ratio
- The efficiency ratios: stock turnover, debtors collection period and creditors payment period
- How to write a proper interpretation comment, not just a number
- The errors that lose marks in the Grade 12 examination
1. Why ratios?
A single figure tells you very little. A net profit of R300 000,00 is impressive for a small business but weak for a giant one. Ratios put the figures into context by comparing them with sales, with equity, with a previous year or with another business. In the examination you normally compare the current year with the previous year and comment on whether the ratio has improved or weakened, why it changed, and what the consequence is.
The standard method is a four-step answer:
- Give the ratio as a figure or percentage with the correct unit.
- Compare it with the previous year (better, worse, or stable).
- Explain the cause using the underlying figures.
- State the consequence for the business.
2. Ratio formulas
| Ratio | Formula | What it measures |
|---|---|---|
| Gross profit margin | Gross profit ÷ Sales × 100 | Profitability of trading before expenses |
| Net profit margin | Profit after tax ÷ Sales × 100 | Overall profitability of every rand of sales |
| Return on equity | Profit after tax ÷ Average equity × 100 | Return earned for the shareholders |
| Current ratio | Current assets ÷ Current liabilities | Ability to pay short-term debts |
| Acid-test ratio | (Current assets − Inventories) ÷ Current liabilities | Ability to pay short-term debts without selling stock |
| Debt-equity ratio | Non-current liabilities ÷ Equity | Financial risk from borrowing |
| Stock turnover | Cost of sales ÷ Average stock | How many times stock is sold and replaced |
| Debtors collection period | Trade receivables ÷ Credit sales × 365 | Average days to collect money from debtors |
| Creditors payment period | Trade payables ÷ Credit purchases × 365 | Average days taken to pay creditors |
Average stock = (opening stock + closing stock) ÷ 2. Average equity = (opening equity + closing equity) ÷ 2.
3. Worked example 1 — profitability ratios
Case: Lulama Ltd for the year ended 30 June 2026.
| Extract | 2026 | 2025 |
|---|---|---|
| Sales | 2 000 000,00 | 1 800 000,00 |
| Cost of sales | 1 200 000,00 | 1 116 000,00 |
| Gross profit | 800 000,00 | 684 000,00 |
| Profit after tax | 300 000,00 | 240 000,00 |
| Equity | 1 200 000,00 | 1 000 000,00 |
Gross profit margin: 800 000,00 ÷ 2 000 000,00 × 100 = 40,0%. In 2025 it was 684 000,00 ÷ 1 800 000,00 × 100 = 38,0%. It improved, which means the company earned more gross profit on every rand of sales — possibly through a higher mark-up or better buying.
Net profit margin: 300 000,00 ÷ 2 000 000,00 × 100 = 15,0%. In 2025 it was 240 000,00 ÷ 1 800 000,00 × 100 = 13,3%. It improved, so the company kept more of each rand of sales as profit after all expenses and tax.
Return on equity: average equity = (1 200 000,00 + 1 000 000,00) ÷ 2 = 1 100 000,00. 300 000,00 ÷ 1 100 000,00 × 100 = 27,3%. Shareholders earned a return of 27,3 cents for every rand of equity, which is a strong return.
| Ratio | 2026 | 2025 | Trend |
|---|---|---|---|
| Gross profit margin | 40,0% | 38,0% | Improved |
| Net profit margin | 15,0% | 13,3% | Improved |
| Return on equity | 27,3% | — | Computed |
4. Worked example 2 — liquidity and solvency ratios
Using the balance sheet extracts for Lulama Ltd:
| Extract | 2026 | 2025 |
|---|---|---|
| Inventories | 200 000,00 | 160 000,00 |
| Trade receivables | 350 000,00 | 300 000,00 |
| Cash and cash equivalents | 50 000,00 | 40 000,00 |
| Current assets | 600 000,00 | 500 000,00 |
| Current liabilities | 250 000,00 | 200 000,00 |
| Non-current liabilities | 300 000,00 | 350 000,00 |
| Equity | 1 200 000,00 | 1 000 000,00 |
Current ratio: 600 000,00 ÷ 250 000,00 = 2,4 : 1. In 2025 it was 500 000,00 ÷ 200 000,00 = 2,5 : 1. The ratio weakened slightly but is still above the ideal of 2 : 1, so the company can comfortably pay its short-term debts.
Acid-test ratio: (600 000,00 − 200 000,00) ÷ 250 000,00 = 400 000,00 ÷ 250 000,00 = 1,6 : 1. In 2025 it was (500 000,00 − 160 000,00) ÷ 200 000,00 = 340 000,00 ÷ 200 000,00 = 1,7 : 1. It remains above the ideal of 1 : 1, which is healthy.
Debt-equity ratio: 300 000,00 ÷ 1 200 000,00 = 0,25 : 1. In 2025 it was 350 000,00 ÷ 1 000 000,00 = 0,35 : 1. The company relies less on borrowed money than before, which lowers financial risk.
| Ratio | 2026 | 2025 | Trend |
|---|---|---|---|
| Current ratio | 2,4 : 1 | 2,5 : 1 | Slightly weaker, still sound |
| Acid-test ratio | 1,6 : 1 | 1,7 : 1 | Slightly weaker, still sound |
| Debt-equity ratio | 0,25 : 1 | 0,35 : 1 | Lower risk |
5. Worked example 3 — efficiency ratios
Additional information for Lulama Ltd: all sales are on credit, credit purchases for 2026 were R1 250 000,00, credit purchases for 2025 were R1 100 000,00, trade payables are R200 000,00 (2026) and R170 000,00 (2025), and stock on 1 July 2024 was R140 000,00.
Stock turnover (2026): average stock = (200 000,00 + 160 000,00) ÷ 2 = 180 000,00. 1 200 000,00 ÷ 180 000,00 = 6,7 times. In 2025 average stock = (160 000,00 + 140 000,00) ÷ 2 = 150 000,00, so 1 116 000,00 ÷ 150 000,00 = 7,4 times. Stock now moves more slowly, which could mean weaker demand or too much stock on hand.
Debtors collection period (2026): 350 000,00 ÷ 2 000 000,00 × 365 = 63,9 days. In 2025 it was 300 000,00 ÷ 1 800 000,00 × 365 = 60,8 days. Debtors are taking longer to pay, which ties up cash. The company may need to tighten credit control.
Creditors payment period (2026): 200 000,00 ÷ 1 250 000,00 × 365 = 58,4 days. In 2025 it was 170 000,00 ÷ 1 100 000,00 × 365 = 56,4 days. The company is taking slightly longer to pay its suppliers. As long as it pays within the credit terms, this keeps cash in the business longer.
| Ratio | 2026 | 2025 | Trend |
|---|---|---|---|
| Stock turnover | 6,7 times | 7,4 times | Slower |
| Debtors collection period | 63,9 days | 60,8 days | Longer |
| Creditors payment period | 58,4 days | 56,4 days | Longer |
Common mistakes
- Using closing stock or closing equity instead of the average in turnover and return on equity. Always average when opening and closing figures are available.
- Writing only the number in an interpretation question and forgetting the comparison, cause and consequence.
- Mixing up the debt-equity ratio (non-current liabilities) with a total-liabilities-based ratio without saying which one is used.
- Forgetting to multiply by 100 when the answer must be a percentage, or by 365 when the answer must be in days.
- Treating a very high current ratio as automatically good. Stock that cannot be sold and debtors who do not pay can still leave the business short of cash.
- Using total sales in the debtors collection period when the question says to use credit sales only.
Quick summary / cheat sheet
| Group | Ratio | Ideal or benchmark |
|---|---|---|
| Profitability | Gross profit margin | Higher is better; compare to prior year |
| Profitability | Net profit margin | Higher is better |
| Profitability | Return on equity | Higher is better; compare to other investments |
| Liquidity | Current ratio | About 2 : 1 |
| Liquidity | Acid-test ratio | About 1 : 1 |
| Solvency | Debt-equity ratio | Lower means less risk |
| Efficiency | Stock turnover | Higher means faster movement |
| Efficiency | Debtors collection period | Shorter means faster cash inflow |
| Efficiency | Creditors payment period | Longer keeps cash longer, if within terms |
Interpretation sentence starter: "The ratio [improved / weakened] from ... to ..., because ..., which means the business ..."
Practice questions
- Gross profit is R450 000,00 and sales are R1 500 000,00. Calculate the gross profit margin.
- Profit after tax is R180 000,00 and sales are R1 200 000,00. Calculate the net profit margin.
- Current assets are R480 000,00, inventories are R160 000,00 and current liabilities are R200 000,00. Calculate the current ratio and the acid-test ratio.
- Non-current liabilities are R400 000,00 and equity is R1 600 000,00. Calculate the debt-equity ratio.
- Cost of sales is R900 000,00, opening stock is R120 000,00 and closing stock is R180 000,00. Calculate the stock turnover.
- Trade receivables are R250 000,00 and credit sales are R1 825 000,00. Calculate the debtors collection period in days.
- Trade payables are R150 000,00 and credit purchases are R1 095 000,00. Calculate the creditors payment period in days.
Answers
- R450 000,00 ÷ R1 500 000,00 × 100 = 30,0%.
- R180 000,00 ÷ R1 200 000,00 × 100 = 15,0%.
- Current ratio = R480 000,00 ÷ R200 000,00 = 2,4 : 1. Acid-test ratio = (R480 000,00 − R160 000,00) ÷ R200 000,00 = R320 000,00 ÷ R200 000,00 = 1,6 : 1.
- R400 000,00 ÷ R1 600 000,00 = 0,25 : 1.
- Average stock = (R120 000,00 + R180 000,00) ÷ 2 = R150 000,00. R900 000,00 ÷ R150 000,00 = 6 times.
- R250 000,00 ÷ R1 825 000,00 × 365 = 50 days (rounded).
- R150 000,00 ÷ R1 095 000,00 × 365 = 50 days (rounded).
Official EduRank Team notes. Always cross-check with your textbook and teacher.