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Ratio Analysis: Profitability and Liquidity (SACE Stage 2 Accounting)

Syllabus dot point

“Calculate and apply profitability and liquidity ratios to evaluate the performance and position of a business”

8 min read

Quick answer

Profitability ratios (such as gross profit margin, net profit margin and return on owner's equity) show how effectively a business generates profit. Liquidity ratios (the current ratio and quick ratio) show whether it can meet short-term obligations. Ratios are calculated from the financial statements and compared over time or against benchmarks.

Jump to a section
  1. What this dot point is asking
  2. Profitability ratios
  3. Liquidity ratios
  4. Worked ratio calculation
  5. What drives each margin
  6. Using ratios well
  7. Exam-style questions

What this dot point is asking

You need to calculate the standard profitability and liquidity ratios, state their formulae, and use them to evaluate a business.

Profitability ratios

Profitability ratios measure how well the business converts activity and resources into profit.

Profitability ratios

Gross Profit Margin=Gross ProfitNet Sales×100Gross\ Profit\ Margin = \frac{Gross\ Profit}{Net\ Sales} \times 100

Net Profit Margin=Net ProfitNet Sales×100Net\ Profit\ Margin = \frac{Net\ Profit}{Net\ Sales} \times 100

Return on Owner′s Equity=Net ProfitAverage Owner′s Equity×100Return\ on\ Owner's\ Equity = \frac{Net\ Profit}{Average\ Owner's\ Equity} \times 100

  • Gross profit margin shows the proportion of each sales dollar left after the cost of goods sold. A falling margin may signal rising supplier costs or discounting.
  • Net profit margin shows the proportion left after all expenses. The gap between gross and net margins reflects operating expense control.
  • Return on owner's equity (ROE) shows the return the owner earns on the funds invested, expressed as a percentage.

Liquidity ratios

Liquidity ratios measure the ability to pay debts due within twelve months.

Liquidity ratios

Current Ratio=Current AssetsCurrent LiabilitiesCurrent\ Ratio = \frac{Current\ Assets}{Current\ Liabilities}

Quick Ratio=Current Assets−Inventory−PrepaymentsCurrent Liabilities−Bank OverdraftQuick\ Ratio = \frac{Current\ Assets - Inventory - Prepayments}{Current\ Liabilities - Bank\ Overdraft}

  • The current ratio is expressed as a ratio to 1 (for example 2:1). A higher figure generally means a stronger ability to meet short-term debts, though an excessive figure can mean idle assets.
  • The quick ratio (acid test) excludes inventory and prepayments because they are less readily converted to cash, giving a tougher test of immediate liquidity.

Worked ratio calculation

Evaluating a small retailer

Figures for the year

Net sales $500,000; gross profit $200,000; net profit $60,000; average owner's equity $300,000; current assets $120,000 (including inventory $40,000); current liabilities $60,000.

Profitability:

  • Gross profit margin =200,000500,000×100=40%= \frac{200{,}000}{500{,}000} \times 100 = 40\%
  • Net profit margin =60,000500,000×100=12%= \frac{60{,}000}{500{,}000} \times 100 = 12\%
  • Return on owner's equity =60,000300,000×100=20%= \frac{60{,}000}{300{,}000} \times 100 = 20\%

Liquidity:

  • Current ratio =120,00060,000=2:1= \frac{120{,}000}{60{,}000} = 2:1
  • Quick ratio =120,000−40,00060,000=80,00060,000=1.33:1= \frac{120{,}000 - 40{,}000}{60{,}000} = \frac{80{,}000}{60{,}000} = 1.33:1

Interpretation: the business keeps 40 cents of gross profit per sales dollar and 12 cents of net profit. A 20% return on equity is sound. Both liquidity ratios exceed 1, so the business can cover short-term debts even without selling inventory.

What drives each margin

Understanding why a ratio moves is what SACE rewards, so it helps to decompose each one. The gross profit margin depends only on selling prices and the cost of goods sold, so it changes when suppliers raise prices, when the business discounts to win sales, or when its sales mix shifts toward lower-margin lines. The net profit margin depends on the gross margin and on operating expense control, so the gap between the two margins is a direct measure of how heavily operating expenses (wages, rent, advertising) weigh on each sales dollar. Return on owner's equity depends on the net profit margin, how efficiently assets generate sales, and the level of gearing, because borrowing lets a given amount of equity control more assets. When a question asks why ROE rose while the net profit margin fell, the answer usually lies in higher asset turnover or increased gearing, an insight that links this dot point directly to the efficiency and stability ratios.

Using ratios well

A single ratio means little in isolation. It becomes useful through comparison: trend analysis (the same ratio over several years), benchmarking (against industry norms or competitors), and cross-checking (reading profitability and liquidity together). A business with strong profit but a current ratio below 1 may be heading for cash trouble.

Common error

Using closing owner's equity instead of average owner's equity in ROE, or forgetting to multiply margins by 100 to express them as percentages. Also, a high current ratio is not automatically good; cash and inventory sitting idle earn no return, so the figure must be interpreted against the business context rather than judged by a single rule of thumb.

Exam-style questions

Questions in the style of SACE Board exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.

2024 SACE Stage 2-style2 marks
Calculate the gross profit margin for Akoya Glare (Illuminated Lighting), using gross profit and net sales from the income statement extract.
Show worked answer →

Gross profit margin = gross profit / net sales, expressed as a percentage.

First find net sales = Sales less Sales returns. Then find gross profit = net sales less cost of goods sold (with COGS adjusted for the stocktake, freight inwards and the closing inventory). Divide gross profit by net sales and multiply by 100.

For example, if gross profit were $382,700 on net sales of $859,500, the margin is 382,700 / 859,500 = 44.5%. This shows the cents of gross profit earned on each dollar of sales before operating expenses.

Markers reward the correct formula, use of net sales (not gross sales) as the denominator, and an answer stated as a percentage. Show the working so method marks are secured even if a figure is mis-keyed.

2023 SACE Stage 2-style2 marks
Calculate the working capital ratio at 30 June 2023 for Great Australian Bytes, then state what the working capital ratio tells Taylor about the liquidity of the business.
Show worked answer →

Working capital (current) ratio = current assets / current liabilities, expressed as a ratio to 1.

Total the current assets (cash, net debtors after the doubtful debts allowance, closing inventory and any prepayment) and the current liabilities (creditors plus accrued electricity), then divide.

Interpretation: the ratio shows how many dollars of current assets are available to cover each $1 of current liabilities. A result comfortably above 1 : 1 (commonly around 2 : 1) means the business can meet its short-term debts as they fall due, so liquidity is sound. A result below 1 : 1 would warn that current liabilities exceed current assets and the business may struggle to pay debts on time.

Markers reward the correct formula and figures, the answer as a ratio, and an interpretation that links the number to the ability to pay short-term debts.

2022 SACE Stage 2-style2 marks
Calculate the profit margin for Espress Yourself for the year ended 30 June 2022. (Profit $111,500; net sales $512,200.)
Show worked answer →

Profit margin = profit / net sales, expressed as a percentage.

Profit margin = 111,500 / 512,200 = 21.8%.

This means the business keeps about 21.8 cents of profit from every dollar of net sales after all expenses. It measures overall profitability and can be compared with prior years or the industry benchmark to judge whether the business is controlling costs and pricing effectively.

Markers reward the correct formula, use of net sales as the denominator, and the answer as a percentage. Showing the working protects the method marks.

Practise this

Sources & how we know this

Based on the official SACE Board subject outline. Not yet individually reviewed by a person; always check SACE Board and your school's materials for current rules.

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