Calculate and interpret profitability, liquidity and efficiency ratios.

Calculate key profitability, liquidity and efficiency ratios and interpret what they mean for decision-makers, with worked figures.

Generated by Claude Opus 4.77 min answerUpdated 2026-05-29

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

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What this dot point is asking

Raw dollar figures are hard to compare, so ratios express one figure as a relationship to another. This lets a decision-maker judge performance and position, and compare across time and between businesses of different sizes. Ratios fall into three main groups for this course.

Profitability ratios

These measure how well the business generates profit from its sales and resources.

Gross\ Profit\ Margin = \frac{Gross\ Profit}{Sales} \times 100

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

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

A higher margin means more profit is kept from each dollar of sales. Return on owner's equity shows the reward earned on the funds the owner has invested.

Liquidity ratios

These measure whether the business can pay its short-term debts.

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

Quick\ Ratio = \frac{Current\ Assets - Inventory}{Current\ Liabilities}

A current ratio around $2:1$ is often regarded as comfortable, though the right level depends on the industry. The quick (or acid-test) ratio is stricter because it removes inventory, which can be slow to convert to cash.

Efficiency ratios

These measure how well assets and working capital are managed.

Inventory\ Turnover = \frac{Cost\ of\ Goods\ Sold}{Average\ Inventory}

Debtors\ Collection\ Period = \frac{Average\ Debtors}{Credit\ Sales} \times 365

Faster inventory turnover and a shorter collection period generally mean cash is freed up sooner.

Worked example

Profitability and liquidity

Given information

Sales $200\,000$ ; Gross profit $80\,000$ ; Net profit $24\,000$ . Current assets $60\,000$ (including inventory $25\,000$ ); Current liabilities $30\,000$ .

Profitability

Gross profit margin $= \frac{80\,000}{200\,000} \times 100 = 40\%$
Net profit margin $= \frac{24\,000}{200\,000} \times 100 = 12\%$

So $40$ cents of every sales dollar is gross profit, but expenses reduce this to $12$ cents of net profit per dollar.

Liquidity

Current ratio $= \frac{60\,000}{30\,000} = 2:1$
Quick ratio $= \frac{60\,000 - 25\,000}{30\,000} = \frac{35\,000}{30\,000} = 1.17:1$

The business holds twice the current assets needed to cover current liabilities, and even excluding inventory it can still cover its short-term debts. This suggests sound short-term liquidity.

Why this matters

Owners, lenders and potential investors all rely on ratios to make decisions about lending, investing or changing how the business operates. Marks in this topic come from correct formulae, correct calculation, and a clear interpretation linked to a decision.